The trading objectives of hedgers, speculators and arbitrageurs.

Hedgers, Speculators and Arbitrageurs are the three major traders in the markets of futures, forward and options. All three of these investors have a great deal of liquidity in the market.

Trading objective of Hedgers

Hedgers are investors, their objective is to use different markets to minimize or eliminate a particular risk that they face from the potential future movements in the market variables (Hull 2010:47). For example, an airline company will enter into a long position to reduce the risk, related to fluctuation in the price of jet fuel, in contrast a farmer who knows that he/she can harvest in the future enters into a short potion in order to reduce the commodity price falls. Hedgers stand not to make a huge gain but moderately to protect their existing position against the price fluctuations. A perfect hedge is rare but investor can reduce their risk which goes against them.

Trading objective of Speculators

Speculators are investors who bet on the future direction of a market variable; either they bet that the price of an asset will go up or down (Hull 2010:13). They take a view on the market and play accordingly, provide liquidity and strength to the market. For example, if a speculator thinks that the British pounds strengthen relative to U.S.doller over the next two months, speculator can purchase British pounds in the sport price and sold it later or can enter into a long position.

Trading objective of Arbitrageurs

Arbitrageurs are investors who trade in two different markets or exchanges; their aim is locking in a riskless profit by simultaneously entering into transaction in two or more markets (Hull 2010:15). For example, shares of IBM trade on both the New York Stock Exchange and the Boston Stock Exchange; suppose that shares of IBM trade for $110 on the New York market and for $ 105 on the Boston Exchange, a trader could make the following two transactions simultaneously:

Buy one share of IBM on the Boston Exchange for $105

Sell one share of IBM on the New York Exchange for $110

This transaction will generate a riskless profit of $5 for the trader (Kolb and Overdahl 2001: 8-9) but this arbitrage opportunity will not fast for a long in the market (Hull 2010:15). Arbitrageurs help markets to bring price uniformity and price discover.

How hedgers use options for hedging.

Hedgers use options for hedging in order to reduce the upcoming risk in their investment in the market.

Illustration:

Following example illustrate hedging strategy of options market,

In April 2011 an investor who owns 1000 Dell shares wants protection against a possible decline in the share price over the next three months. Market quotes are as follows:

Current Dell share price: $28

Dell July 27.50 put price: $1

A contract is 100 shares, thus investor should buy 10 contracts for 1000 shares; quoted price of an option is $1 per share, therefore total cost of hedging strategy will be $1,000;

The investor could buy 10 put option contracts on Dell on the Chicago Board Options Exchange for a total cost of $1000 with a strike price of $ 27.50; this gives the investor the right to sell 1000 shares for $ 27.50 per share during the next three months (Hull 2010:11).

If the market price of Dell falls below $27.50 say for $ 26, the option will be exercised and the investor will realize $27,500 as a whole; How ever investors actual realized amount is $26,500 ($27,500- $1000) (Hull 2010:12). And he/she can buy 1000 Dell shares in the market for $26,000 ($26 x 1000), thus there will be profit of $500($26500 – $26000) by contrast if the market price is above $27.50, say $28, the options are not exercised and expire worthless because the investor can earn more profit if he/she sells for market price than the option strike price, however the actual profit is after deducting the option premium of £1000.

How speculators use options for speculation.

In a speculation the trader has no exposure to offset; they use options to take a position in the market. Either they are betting that the price of the asset will go up or they are betting that it will go down (Hull 2010:13).

Illustration:

Following example illustrate speculation strategy in options market,

A speculator who in October thinks that Microsoft share is likely to increase in value over the next two months;

Current Microsoft share price: $20 per share

Microsoft December call option with a 22.50 Strike price is: $1

Speculator’s investment is: $2000

The two alternative speculation strategies as follows;

Investor’s Strategy

December Share Price

$15 $27

Buy 100 shares

Buy 2000 call options

-$500

-$2,000

$700

$7,000

Table 1: Comparison of alternative speculation strategy used buy speculators in option

Suppose the speculator’s hunch is correct and the price of the stock rises to $27 by December, the first alternative of buying the stock yields a profit of 100x ($27 – $20) = $700; However, the second alternative is far more profitable, call option on the stock with a strike price of $22.50 gives a payoff of $4.50 ($27 – $22.50), thus the total payoff from the 2000 options that are purchased under the second alternative is 2000 x $4.50 = $ 9,000 Subtracting the original cost of the options yields a net profit of $9,000 – $ 2,000 = $7,000; therefore option strategy is therefore ten times more profitable than the strategy of buying the stock (Hull 2010:14).

By Contrast option also gives rise to a grate potential loss. Suppose the stock price falls to $15 by December: The first alternative of buying stock yields a loss of 100 x ($20 – $15) = $500 and because the call options expire without being exercised, the option strategy would lead to a loss of $2000 that the original amount paid for the option (Hull 2010:14).

How arbitragers use options.

Arbitrage involves taking a position in two or more different markets to lock in a profit.

Three (3) factors that may affect pricing of options.

There are several factors affecting the pricing of options, out of which the three main factors are;

Stock Price (S) & Strike Price (K)

The Expiration Date (T)

Volatility of the stock price (σ)