This monthly educational series will feature the basic workings of the futures and options markets and how they can be utilized to help farmers with risk management.
IN THIS LESSON we continue our look at market participants with a specific focus on speculators. Speculation is the practice of engaging in risky financial transactions in an attempt to profit from fluctuations in the market value of a tradable good, such as futures contracts. This is in contrast to more conservative investments, such as capital gains, interest, or dividends, which investors attempt to profit from through the underlying financial attributes they offer.
Speculators pay little attention to fundamentals; they focus on price movement and technical analysis or external events that affect price movement. Speculators put their own money at risk for a quick profit and must be prepared to accept any losses due to price fluctuations in the futures market. Speculators analyze the market and forecast futures price movement as best they can. The smart speculator does not operate blind. They are willing to accept risk for the possibility of reward.
Speculators add an important element to the futures market in the form of liquidity. For example, assume you have a very high priced painting worth $10,000. If you decided to put an ad in your local paper for best offer, you may get a phone call offering you $1,000. If instead you place the painting in an art auction at Sotheby’s, the number of art enthusiasts following the auction (liquidity) may push your starting bid to $5,000.
The same situation applies to the futures markets which have thousands of producers, end users, and speculators bidding for your commodity. Using the Chicago corn market as an example, an order entered as a market order may be filled immediately within a half cent per bushel from the posted price due to the amount of interested participants (liquidity).
Speculators earn a profit when they offset futures contracts which have moved in the direction that they anticipated. A typical speculator might consider selling gold (shorting) when they feel the price is too high in hopes of buying it back or closing his position when the price retreats to his predicted level. The difference in the sell price and the buy price, times the multiplier of that contract (100 ounces for gold), becomes the profit or loss sustained by the speculator.
If the speculator decided to buy December gold contract at $1,200 per ounce and sell it when it rises to $1,225 per ounce, he would realize a profit of $25 x 100 ounces ($2,500). Conversely, if he felt the price of gold was going to drop, he would (short) sell the contract at $1,200 per ounce and buy it back when it weakens to $1,180 per ounce. Their profit would then be $1,200 – $1,180 or $20 per ounce x 100 ounces ($2,000).
Without the speculator, the only market participants would be the actual producers and end users. Getting the price you want, whether buying or selling, could take more effort on everyone’s part. The speculator is willing to take the risk away from the buyer and seller in hopes of making a profit, thereby transferring risk and adding liquidity to the market. •
Marty Hibbs is a 25 year veteran futures trader, analyst, and portfolio manager. Hibbs was a regular guest analyst on BNN for four years. He is currently a grain merchandiser with Grain Farmers of Ontario.
Liquidity: The measurement of a market’s ability to facilitate an asset being sold quickly without having to reduce its price. It reflects the volume of interested parties trading in that particular product.
Short: The practice of selling a seemingly overpriced investment in hopes of buying it back for less at a later date.