As derivative contracts are bought by retail 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 a derivative market are: Hedgers, Speculators, Arbitrageurs.
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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 pursuing reduction of risk is known as a Hedger. A Hedger would usually strive at reducing his asset exposure to price volatility and in a derivative market, would take up a position that is opposite to the risk he is exposed to. Hedgers use different derivative strategies in order to reduce or eliminate price risk.
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, you are holding a long position in these shares), the loss you realized from shares could be compensated by the profit you achieved from short position in 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 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 February maturity. The futures price would be 1.55 USD/lb.
1st scenario: on February 25th 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 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 hypothesize expected price movements and take accordant positions to maximize their gains. Speculators are risk takers, their affinity to risk is much higher than that of a risk-averse investor. They participate in the derivative markets merely for the purpose of profit making. They need to effectively make predictions for future market trends in order to take positions. Such behavior does not in any way guarantee them safety of capital they invested or returns.
Speculators rely on fast moving trends to forecast possible market moves. 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 wholesale indicators, consumer 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 can make huge profits or an equally huge losses and are typically high net investors, who strive at diversification of their positions and always pursue profit maximization in a short period of time.
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.
Arbitrageurs play in an extremely fast paced environment with decisions being made at the blink of an eye, literally. Sometimes the price of a share in the cash market is lower or higher than it should be, compared to its price in the derivatives market. Arbitrageurs exploit these imperfections and inefficiencies to their advantage. They also play an important role in increasing liquidity in the market. An arbitrage opportunity is available, if an investor suffers no costs, regarding purchasing or organizing a certain position in derivative instruments, always realizes 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. Cash-Futures arbitrage is one of the simplest forms. If the futures price is trading at a premium to its base asset, it is referred to as a Contango. If the premium post adjustment for transaction costs gives higher returns than the cost of capital, an arbitrageur will take positions to benefit from this opportunity. If the futures price is at discount to its base asset, the situation is referred to as Backwardation.