Types of Market Players and Classification

Let us give a simple example. If the spot market price of the shares drops (presumably, a trader is holding a long position in these shares), the loss he or she incurs on the shares could be compensated by the profit realised from the short position in the derivative instrument (futures, for example).

Every hedger transacts today in the futures market, where prices are known, while the results of these transactions will materialise tomorrow in the spot market, where prices are still unknown.

Let us give another example. A farmer produces 25,000 lbs of pork and wishes to sell it on February 25th. The spot price for pork is USD 1.50 per lb, while the futures price for February delivery is USD 1.55 per lb. What action should the farmer take if he is concerned that the price may fall before February 25th, and at what price can he lock in the sale? In this case, the farmer would take a short position in one futures contract maturing in February at a price of USD 1.55 per lb. Let us examine two scenarios.

1st scenario: on February 25th the spot price for pork declines to USD 1.45 per lb. The farmer sells pork for: USD 1.45/lb * 25,000 lb = USD 36,250. He then buys back the futures contract at a profit of (USD 1.55 – 1.45) * 25,000 = USD 2,500. The total revenue amounts to 36,250 + 2,500 = USD 38,750.

2nd scenario: on February 25th the spot price for pork increases to USD 1.60 per lb. The farmer sells pork for: USD 1.60/lb * 25,000 lb = USD 40,000. He then buys back the futures contract at a loss of (USD 1.55 – 1.60) * 25,000 = – USD 1,250. The total revenue amounts to 40,000 – 1,250 = USD 38,750.

Speculators

Speculators typically try to anticipate price movements and enter positions accordingly in order to maximise their gains. We can say that speculators are risk-takers – their appetite for risk is much higher than that of a risk-averse investor. They participate in the derivatives markets purely to profit. To position themselves correctly they must forecast future trends effectively. Such behaviour in no way guarantees the safety of the funds they have deposited, nor any return.

Speculators aim to detect and ride fast-moving trends so that they can anticipate the market’s direction. To do so, they employ technical analysis methodology alongside analysis of fundamentals. Fundamental factors may range from changing consumer sentiment and expectations to fluctuating interest rates, retail-sales or consumer-spending indicators, consumer-price and producer-price indices, gross domestic product for a country or region, or even a single public statement by experts, CEOs or presidents of prestigious, internationally renowned corporations and institutions. Speculators may earn substantial gains or suffer equally large losses and are usually high-net-worth investors who seek to diversify their investment portfolios. They always pursue short-term profit maximisation.

Example

For example, if a speculator believes that the share price of ‘ABC’ will decrease in three days’ time owing to upcoming market developments, he would usually take a short position in these shares via the derivatives market, even though he does not necessarily own them. If the share price falls as expected, he will make a sizeable profit, depending on the number of shares involved. However, if the price rises against expectations, he will incur a proportional loss.

Let us have another example with a speculator trading in the currency market. Presumably, he follows the behaviour of a news trader (fundamental analyst) and he places bets on the EUR/USD pair. The speculator anticipates the release of the Eurozone’s Gross Domestic Product (GDP) report for the third quarter, the broadest indicator of the region’s economic activity, and is aware of the consensus forecasts for GDP growth. Suppose the median estimate of economists suggests that the Eurozone’s GDP will expand by 0.3% during the third quarter.

If the speculator believes that the region’s GDP will exceed analysts’ forecasts, he will enter the market by opening a long position in the EUR/USD pair (buying the euro and selling the US dollar, as we already discussed in one of the previous articles), expecting the pair to appreciate because of the stronger-than-projected GDP figure. (We shall examine the various economic, political and other fundamental indicators at a later time).

If the official report shows that economic growth is higher than predicted, say 0.5% in the third quarter, the value of the EUR/USD pair will indeed rise and the speculator will make a sizeable profit, depending on the number of units he holds, because he is long the pair.

Conversely, if the report shows growth below expectations, say 0.1% in the third quarter, the value of the EUR/USD pair will fall and the speculator will incur a loss, as his expectations have been disproved.

These examples again underscore the fact that speculating in the markets is accompanied by a high level of risk.

Arbitrageurs

Arbitrageurs operate in an extremely fast-paced environment, where decisions are taken in the blink of an eye. At times, the price of a share in the spot market may be lower or higher than its price in the derivatives market. Arbitrageurs seek to exploit and thereby eliminate such imperfections and inefficiencies. They also play a key role in increasing market liquidity.

An arbitrage opportunity exists if an investor can, at no cost, establish a position in derivative instruments, incur no risk and realise a positive gain. These three characteristics must be present simultaneously. Typically, such opportunities exist for only a brief moment before they disappear.

There are various forms of arbitrage; spot-futures arbitrage is one of the simplest.

If the futures price of an underlying asset (a commodity, for example) is higher than its spot price, the market is said to be in contango. In this situation the arbitrageur is willing to pay more for the commodity at a future date than the current expected price. He may do so in order to avoid the costs of storage and carry that would be incurred by buying the commodity today.

If the futures price of an underlying asset is lower than its spot price, the market is said to be in backwardation (or normal backwardation).