Hedgers Speculators and Arbitrageurs in the function of the market
Hedgers, Speculators and Arbitrageurs are essential for a good functioning of the market. Hedgers and investors give the economic soul to any financial market. Without them the markets would lose their goal and become ordinary tools of gambling. Speculators give liquidity and depth to the market. Arbitrageurs bring price consistency and help price discovery. Markets help in effective move of risk from Hedgers to speculators.
Normally hedger are wish to eliminate or reduce the price risk, Hedgers are those market players who set up a futures position for the intention of decreasing the price risk that arises as part of their normal, current business. By so doing, the risk is moved to other hedgers who have the opposite character or, more likely, to speculators who take the risk to earn profit. For example, a farmer who expecting to have a harvest of tea to sell in the fall may sell tea futures prior to harvest as a hedge against a drop in price of tea. (Hedgers provide the main motivation and justification for the establishment of the futures market.
Speculators want to increase their gain by making profits in a fluctuating market. Speculators are those market players who trade futures for the purpose of earning profit. This type of group consists of the majority of traders for most of the markets. Speculators take risk in the confidence of earning profit by buying low price and selling high, or by first selling high price and later buying back low.
ARBITRAGERS
Arbitrager is a type of investor who tries to gain risk low profit by taking the advantage of price differences. Arbitragers profit from price differences which are there in two dissimilar markets by simultaneously running in two. Example - Arbitragers hunt for price variation between the stocks which are listed in two different exchanges market and buying the one which has lesser price in one exchange and by selling the stocks in another exchange whose price in higher.
OPTION
An option contract is an agreement between two parties to buy or sell an asset at a certain date and certain price in the future. It is called an option because the buyer is not obligated to buy the assets. If over the life time of the contract, the asset price value decline, the buyers can decide not to exercise his or her right to buy or sell the asset.
In option there are two types of options
Call option - A call option is an option to buy a certain asset by a fixed date for a fixed price.
Put option - A put option is an option to sell a certain asset by a fixed date for a fixed price.
Example: Rohan buys a Call option contract from Leeza. The contract says that Rohan will buy 1000 john keells shares from Leeza on the 15th April for $50. The current share price for Microsoft is $60.
This is an example of a Call option as it gives Rohan the right to buy the certain asset.
If the share price of john keells is trading above $50 on the 15th April, then Rohan will exercise the option and Leeza will have to sell him john keells shares for $50. With john keells trading anywhere above $50 Rohan can make an spot profit by taking the shares from Leeza at the promised price of $50 and then selling the shares on the open market for whatever the present share price is and making a profit.
The $50 worth, which is said in the agreement, is concerned to as the Strike Price. This is the price at which the share will be exchanged.
The date (in this case 15th April) is known as the Maturity Date. This date is the closing date for the option contract. At this dead line date, the option buyer is to decide if a transaction of the certain asset (john Keells share) is to occur.
Let's think that at the maturity date, John Keells is trading at $60, then Rohan will buy the shares from Leeza at the promised price $50 and then he can sell them back on the open market for $60 and make an instant profit $10.
On other hand, if John Keells is trading at $40, then buying the shares from Leeza at $50 is very expensive as he can buy them on the open market for $40 and save $10. In this case, Rohan can decide not to exercise his right to buy the John Keells shares and let the options contract expire valueless. His only loss is which he paid to Leeza when he bought contract in his earlier stage.
On other hand both parties can go for Put option too. So according to our example Rohan bought a call option from Leeza. Rohan also can buy a put option from Leeza. Buying a put option means that Rohan buys the right to sell John Keells shares at $50 on the 15th of April. Thus Rohan will make a profit if the market is below $50 on the day of Maturity.
Consuming put options can give investors to profit when the market goes down without having to sell short stock.
Consumers of put options have limitless profit potential if markets begin to sell off. Put option holders have restricted risk if the market goes against them.
SPECULATION
Options are one of the best ways to speculate on the future of a stock or even the overall market. A single option means basically it is price of 100 shares and even a marginal variation in the share price is multiplied a 100 times when you trade in options. This makes it very simple to make big gains with a single decision.
Example
Assume that it is April and a speculator considers that ABC share is likely to rise in price over the next two months. The stock price is currently $ 50, and a two month call option with a $ 55 strike price is currently selling for $2. The following two possible alternatives assuming that speculator is willing to invest $ 5000. The first substitutes way is involves the purchase of 100 shares. The second way is purchase of $ 2500 call options (25 call option contracts)
Assume that the speculator's calculation is correct and the price of ABC shares rise to $80 by December. The first alternative of buying the stock yield a profit of
100 x ($80-$50) = $3000
The 2nd possibility is far more profitable. A call option on ABC
From the trade's desk- April
A speculator with $ 5000 to invest hopes that the price of ABC will increase in the next two months and has obtained the following quotes.
Current stock price is $ 50
ABC June call with a $ 55 strike price $2
Alternative strategies
1. Buy 100 shares of ABC
2. Buy 2500 June call options (or 25 June contracts) on ABC with a $ 55 strike price.
The cost of each alternative is $ 5000
Possible outcomes
1.ABC increase to $ 80 by June. The investor makes a profit of $3000 using the first strategy and $ 56000 using the second strategy.
2. ABC falls to $ 40 by june. The investor losses $1000 with the first strategy and $4000 with the second strategy
The speculator's expectation on the asset's situation will determine what sort of options strategy that he can take. If the speculator determines that share will increase in price, he should buy call options that have a strike price that is lesser than the expected price level. In this case that the speculator's expectation is correct and the share's price does certainly go up substantially, the speculator will be can close out his position and realize the profit by selling the call option for the price that will be same to the variations between the strike price and the market price. And also if the speculator believes that share will fall in price, he able to purchase put options with a strike price that is higher than the expected price level. If the price of the share does lesser than put option's strike price, the speculator can sell the put options for a price of share that is equal to the variance between the strike price and the market price in order to realize any applicable profits.
ARBITRATIONS
Arbitrage means buying & selling of a financial instrument in order to profit from price differentiation. This normally happens between two different exchanges, practically occurs between a domestic and foreign exchange.
AN OPTION PRICING
An option pricing is affected by so many factors, of the price of an option is based on these main three factors:
1. Stock price
2. Volatility of underlying
3. Rate of interest
Strike Price
Strike price is the contracted price which would be exchanged in the case of the exercise of the option by the buyer of the contract. Thus strike price plays main role in determining price of an option contract. The exercise price will stay on the same during the life of an option contract and it will never change. But in the case of a stock split there would be different in the strike price.
Volatility of underlying
Volatility means standard deviation of the value of the underlying over a defined period of time. If a market goes more volatile, the premium for option contracts will be goes up. Someone who bought options earlier time would be benefited to the loss of someone who previously sold options. Buying options prior to such volatility development has a high probability of success.
Price of underlying
The price of underlying is the main factor that committed the price of an option. The price of an option for a given strike price will undergo change over based on the price of underlying stock. The closer the market price is to the strike price of contract, the rate of different will be the highest. . For strike prices main away from the market price, the rate of difference of option premium will be lower.
