Types of Market Players and Classification
This lesson will cover the following
- Why different players participate in the Forex market
- What is a hedger
- What is a speculator
- What is an arbitrageur
In this article we are focusing on the behavior of different types of market players, who are trading in the currency market using derivative instruments such as futures or options. As derivative contracts are bought by private and institutional players with varied needs, market participants are defined by the purpose by which they choose to trade in derivatives. The important players in the derivative market, (including those trading futures and options on currency pairs), are: hedgers, speculators and arbitrageurs.
We could say that ”hedging’’ simply means a reduction of risk, enclosing a position in order to restrain it from risky factors/influences coming from current market situation. An investor who is aiming to reduce the level of risk is usually called a hedger. A Hedger would usually strive at reducing the exposure of his/her position to price volatility and in a derivative market, would enter into a position, which is opposite to the risk he takes. Hedgers use different derivative strategies in order to reduce or eliminate price risk.
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For example, an investor intends to purchase 1000 shares of company ‘’ABC’’, but also wants to ensure this long position against market trend, especially in times of high volatility. Consequently, he should take short position of the same amount of ‘’ABC’’ futures to form a hedge. Such action would reduce his exposure to unfavorable situations or events that cause influence upon the whole market.
Let us give a simple example. If spot market price of shares drops (presumably, a trader is holding a long position in these shares), the loss he/she registers from shares could be compensated by the profit he/she achieves from short position in the derivative instrument (futures, for example).
Every hedger makes transactions today in the futures market, where prices are known, while the results of these transactions are expected to appear tomorrow in the spot market, where prices are still unknown.
Let us give another example. A farmer produces 25 000 lbs of pork and would like to sell it on February 25th. Spot price for pork is 1.50 USD for 1 lb. Futures price on February 25th is 1.55 USD for 1 lb. What action would the farmer take, if there were concerns, that the price would be lower until February 25th? Or what price would he lock-in? In this case, the farmer would take short position in 1 futures contract with maturity in February. The futures price would be 1.55 USD/lb. Let us examine two scenarios.
1st scenario: on February 25th the spot price for pork declines to 1.45 USD/lb. The farmer sells pork for: $1.45/lb * 25 000 lb = $36 250. Then he buys back the futures contract with a profit of ($1.55 – $1.45)* 25 000 = $2 500. The total profit amounts to 36 250 + 2 500 = $38 750.
2nd scenario: on February 25th the spot price for pork increases to 1.60 USD/lb. The farmer sells pork for: $1.60/lb * 25 000 lb = $40 000. Then he buys back the futures contract with a loss of ($1.55 – $1.60)* 25 000 = – $1 250. The total profit amounts to 40 000 – 1 250 = $38 750.
Speculators usually try to project price movements and enter into respective positions in order to maximize their gains. We can say that speculators are risk takers, their affinity to risk is much higher than that of a risk-averse investor. They participate in the derivative markets simply in order to profit. They need to effectively make predictions for future trends in order to appropriately position themselves in the market. Such behavior does not in any way guarantee them safety of funds they deposited or returns.
Speculators usually try to catch and ride fast moving trends, so that they could project in what direction the market will go. In this case they use technical analysis methodology alongside analysis of fundamentals, as the latter could range from changing consumer sentiment, expectations, to fluctuating interest rates, retail sales or consumer spending indicators, consumer price and producer price indexes, gross domestic product for a country/region, or just a single public statement by experts, CEOs, Presidents of prestigious and internationally renowned corporations and institutions. Speculators are able to register large gains or equally huge losses and usually belong to the group of high net investors, who strive at diversification of their investment portfolios. They always pursue profit maximization within a short term.
For example, if a speculator believes the share price of “ABC” is expected to decrease in three days time given some upcoming market developments, he would usually position himself short in these shares (he would sell them) in a derivative market as he is not necessarily in possession of those shares. If the stock price falls as expected, he will make a sizeable profit, depending on the quantity of shares he is holding. However, if the stock price rises, opposing expectations, he will make a commensurable loss.
Let us have another example with a speculator trading in the currency market. Presumably, he follows the behavior of a news trader (fundamental analyst) and he places bets on EUR/USD pair. The speculator expects the release of a report on Euro zones Gross Domestic Product (GDP) during the third quarter of the year, the broadest indicator for regions economic activity, and he is familiar with what experts project about the pace of growth of the GDP figure. Presumably, the median estimate of economists points that Euro blocs GDP will expand at 0.3% during the third quarter of the year.
If the speculator believes that regions GDP will exceed experts forecasts, he will enter the market, by opening a long position in the EUR/USD pair (or buying the euro and selling the US dollar, as we already discussed in one of the previous articles), as he expects that the value of the pair will increase, because of the better-than projected GDP figure. (We shall examine the different economic, political and other indicators (fundamentals) at a later time).
In case the official report states a pace of economic growth, which is greater than the predicted pace, say 0.5% during the third quarter of the year, the value of EUR/USD pair will indeed increase and the speculator will make a sizeable profit, depending on the units of this pair he is holding, because he has entered into a long position at the time.
But, in case the official report states a pace of economic growth, which is below expectations, say 0.1% during the third quarter, the value of EUR/USD pair will start to decrease and the speculator will register a loss, as his expectations have been defied.
With these examples we again stress on the fact that speculating in the markets is accompanied by a high level of risk.
Arbitrageurs usually participate in an extremely rapid environment, with decisions being made at the blink of an eye, literally. Sometimes the price of a share in the spot market may be below or may exceed its price in the derivatives market. Arbitrageurs usually look to dispose of such imperfections and inefficiencies in the market. They also play a key role in increasing markets liquidity.
An arbitrage opportunity is available, if an investor suffers no costs, regarding purchasing or organizing a certain position in derivative instruments, always registers positive gains, takes no risk. These three characteristics must be present simultaneously. Usually, arbitrage opportunities appear for a very limited amount of time, after which they vaporize instantly.
There are various arbitrage opportunities that can be explored. Spot-Futures arbitrage is one of the simplest forms.
If the futures price of an underlying asset (commodity, for example) is at a premium (higher) in comparison with the spot price of the same asset, this situation is referred to as a Contango. This means that the arbitrageur is willing to pay more for this commodity at some point in the future, than the actual expected price of the commodity. This may be a result of his desire to pay a premium to have the commodity in the future, rather than paying the costs of storage and costs of carry, when buying the commodity today.
If the futures price of an underlying asset is at a discount (lower) in comparison with the spot price of the same asset, this situation is referred to as Normal Backwardation, or simply Backwardation.