Hedgers wish to eliminate or reduce the price risk to which they are already exposed. Hedging is a mechanism which is used to reduce price risk inherent in open positions. Derivatives are widely used for hedging (forward Contracts/options). A Hedge can help lock in existing Price (profits). Its purpose is to reduce the volatility of a portfolio, by reducing the risk. It needs to be noted that hedging does not mean maximization of return. It only means reduction in variation of return. It is quite possible that the return is higher in the absence of the hedge, but so also is the possibility of a much lower return.
Speculating
Speculators are investors who willingly take price risks to profit from price changes in the underlying. Speculators wish to take position in the market. Either they are betting that the price of an asset will go up or they are betting that it will drop. These people do not actually buy or sell the commodities nor do they have any intention to do so. Their sole motive in getting involved in futures trading is to get profit from the change in price. They buy when they think the prices of a particular commodity will go up in future and they sell if they think that the prices of a particular commodity will go down in future.
Arbitrage
Arbitrager is an investor who attempts to gain profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits. An arbitrageur would, for example, seek out price discrepancies between stocks listed on more than one exchange, and buy the undervalued shares on one exchange while short selling the same number of overvalued shares on another exchange, thus capturing risk-free profits as the prices on the two exchanges converge. Although arbitrage opportunities do exist in real markets, they are usually very small and quickly eliminated in Finance Market.
How hedgers use Options for hedging
An option is a contract that gives you the right to buy or sell some asset at a predetermined price
"Call" option gives you the right to buy the underlying stock.
"Put" option gives you the right to sell the underlying stock.
An investor who owns a particular amount of shares, concerned about a possible share price decline in near future and wants protection can go for "Put" option which gives the investor the right to sell his shares for the agreed price. Same can happen other way around. If an investor who is interested in buying a particular amount of shares in near future concerned about share price increase can go for a "Call" Option which gives the investor the right to buy the shares for the agreed price.
Options, by contrast, provide insurance. They offer a way of investors to protect themselves against adverse price movements in future while still allowing them to benefit from favorable price movements.
Example
Mr. Smith, who in May owns 1000 Microsoft shares, the share price is 30$ per share. Mr. Smith concerned about a possible share price decline in next 3 months and wants protection. Mr. Smith goes for 10 "Put" options(100*10) on Microsoft on Chicago board options exchange with a strike price of 29.50$.the quoted option piece is 1$.
The total cost for the hedging strategy will cost (1000x1$) 1000$ bit gives Mr. Smith the right to sell his shares for at least for 29.50$. This will be exercised only if the market price of Microsoft shares falls below 29.50$.
How speculators use options for speculation
Speculators use options to get advantage from the anticipated price movements in the underlying financial instrument (e.g. a share price) without having to risk a large amount of capital on shares itself. Speculators hope to benefit from the same profits that would've accrued if they had risked the larger sum on the shares.
The speculator's anticipation on the asset's situation will determine what sort of options strategy that he or she will take. If the speculator believes that an asset will increase in value, he or she should purchase call options that have a strike price that is lower than the anticipated price level. In the event that the speculator's belief is correct and the asset's price does indeed go up substantially, the speculator will be able to close out his or her position and realize the gain (by selling the call option for the price that will be equal to the difference between the strike price and the market value). On the other hand, if the speculator believes that an asset will fall in value, he or she can purchase put options with a strike price that is higher than the anticipated price level. If the price of the asset does fall below the put option's strike price, the speculator can sell the put options for a price that is equal to the difference between the strike price and the market price in order to realize any applicable gains.
Example
Suppose a trader has $2,000 to invest, the trader considers that the stock price of ABC likely to increase in value over next 2 months. ABC stock costs $50 and an ABC call option (with a strike price of $50 that expires in 2 months) costs 2$ each. The Trader has 2 alternatives. One alternative is to purchase 40 shares (2000/50); the other is to purchase 1000 call options (2000/2). Suppose the speculators hunch is correct and the stock price rises to 55$ after 2 months time.
1st alternative
40($55 - $50) = $200
2nd alternative
Gain from the options 1000 x $5 = $5000
Net gain $5000 - $2000 (Options Expence)
$3000
***How ever the second alternative is far more profitable. A call potion on the stock with a strike price of $50 gives a payoff of $5 because it enables something worth $55 to be bought for $50.
How arbitrages use Options
