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Basics of Derivatives

Speculator

We will discuss the next type of market participant, known as the ‘Speculator.’

 

Speculators are individuals who take large risks, especially with respect to anticipating future price movements, in the hope of making quick, large gains. Speculators can achieve these profits by buying low and selling high and vice-versa.

 

Their investment horizon is very short term in nature and hence they use futures markets where they also have to spend less (only margin money required) as against full amount in the spot market.

 

Speculating Through Futures

 

Speculating in the equity market or any other market could be possible by using various types of derivatives products. Speculating via uses of futures contracts is one of the simplest and yet highly rewarding forms if one's expectation of future price movement is correct.

 

  • Bullish on security, Buy futures
  • Bearish on security, Sell futures

Bullish on security, Buy futures

 

An investor holds a view that a particular security that trades at ₹1000 is undervalued and expects its price to go up in the next two-three days. So, he buys 100 shares which cost him one lakh rupees. His hunch proves correct and three days later the security closes at ₹1010 and he make a profit of ₹1000 on an investment of  ₹1,00,000 for a period of three days. This works out to return of one percent.

 

Today a speculator can take exactly the same position on the security by using futures contracts.

 

The security trades at ₹1000 and the one-month futures trades at ₹1002. Just for the sake of comparison, assume that the minimum contract value is ₹1,00,000 and he buys 100 security futures for which he pays a margin of ₹20,000.

 

Two days later the security closes at ₹1012. He makes the same profit of  ₹1000 on an investment of  ₹20,000. This works out to a return of five percent.

 

Thus, using futures the speculator has made a ROI of around 5% in a short period as against 1% if he would have used the cash market.


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Bearish on security, Sell futures

Stock futures can also be used by a speculator who believes that a particular security is over- valued and is likely to see a fall in price. To trade based on his opinion all he needs to do is to sell stock futures. Futures on an individual security move correspondingly with the underlying security, as long as there is sufficient liquidity in the market for the security. 

 

If the security price rises, so will the futures price. If the security price falls, so will the futures price.

 

Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one two-month contract of futures of ABC Ltd. at ₹240 (each contact for 100 underlying shares). He pays a small margin on the same.

 

Two months later, when the futures contract expires, ABC closes at ₹220. On the day of expiration, the spot and the futures price converge. He has made a clean profit of  ₹20 per share. 

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