Speculation and Leverage
A speculatorIn finance, speculation is the purchase of an asset with the hope that that asset will become more valuable in a brief amount of time. The term can also refer to short sales, in which the speculator hopes to profit from a decline in the asset's value. Speculation often has a pejorative connotation, as the activity is linked to bubbles, economic downturns, and financial crises.Read on Wikipedia → takes a market risk to try to earn a profit. Someone who expects the pound to rise might buy pounds or take a contract whose value rises with the pound. Unlike a company protecting a supplier payment, the speculator does not need an existing business risk to justify the trade.
DerivativesIn finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements:an item that can or must be bought or sold, a future act which must occur, a price at which the future transaction must take place, and a future date by which the act must take place.Read on Wikipedia → can provide a large position for a relatively small initial payment. This is leverageIn finance, leverage, also known as gearing, is any technique involving borrowing funds to buy an investment.Read on Wikipedia →. It increases the possible gain or loss relative to the money first committed.
Buying currency or taking a futures position
In Hull’s historical example, a trader expects the pound to strengthen over two months and wants a position covering £250,000. The trader can buy the pounds directly or buy four futures contractsIn finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative. Futures contracts are widely used for hedging price risk and for speculative trading in commodities, currencies, and financial instruments.Read on Wikipedia →, each covering £62,500.
Buying the currency at $1.2220 per pound requires $305,500. The futures price is $1.2223 per pound, but the trader does not pay the full value of the currency to open the position. The example requires $5,000 of initial marginIn finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:Borrowed cash from the counterparty to buy financial instruments, Borrowed financial instruments to sell them short, Entered into a derivative contract.Read on Wikipedia → per contract, or $20,000 in total. Margin is security for the position’s obligations.
| Outcome after two months | Buy £250,000 directly | Buy futures covering £250,000 |
|---|---|---|
| Pound reaches $1.3000 | +$19,500 | +$19,425 |
| Pound falls to $1.2000 | −$5,500 | −$5,575 |
For the futures position, the first result is:
£250,000 × ($1.3000 − $1.2223) per pound = $19,425The two methods produce similar dollar results, but require very different amounts of money initially. That is the source of the leverage. The calculations exclude interest and fees, so the small differences in the table do not show that one method is generally better.
The $20,000 margin is not a limit on losses. A sufficiently large move against the position can produce a larger loss, and regular futures settlements may require further cash before the two months end.
Buying shares or buying calls
OptionsIn finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option.Read on Wikipedia → provide another way to take a position. A call optionIn finance, a call option is an option contract that gives its buyer the right, but not the obligation, to buy an agreed quantity of a particular commodity, security, or other financial instrument from the seller at a specified price. The asset or instrument to which the option relates is known as the underlying, and the specified purchase price is known as the strike price. The right may be exercisable at or before a specified date, depending on the terms of the option.Read on Wikipedia → gives its buyer the right to buy shares at an agreed strike priceIn finance, the strike price of an option is a fixed price at which the owner of the option can buy, or sell, the underlying security or commodity. The strike price may be set by reference to the spot price, which is the market price of the underlying security or commodity on the day an option is taken out. Alternatively, the strike price may be fixed at a discount or premium.Read on Wikipedia →. The buyer pays a premiumIn finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option.Read on Wikipedia → for that right.
In the chapter’s second example, a share costs $20 and a two-month call with a $22.50 strike costs $1 per share. With a $2,000 budget, a trader can buy 100 shares or options covering 2,000 shares. At 100 shares per contract, the second choice means 20 option contracts.
Suppose the share price reaches $27 at expiry. The 100 shares produce a $700 gain. Each option provides a $4.50 benefit: the right to buy a $27 share for $22.50. Across 2,000 shares, that is $9,000. Subtracting the $2,000 premium leaves $7,000 profit.
If the share price falls to $15, the shares lose $500. The calls expire without value, so the option buyer loses the full $2,000.
| Share price at expiry | Profit on 100 shares | Profit on calls covering 2,000 shares |
|---|---|---|
| $27 | +$700 | +$7,000 |
| $15 | −$500 | −$2,000 |
The option buyer needs more than a rising share price. At expiry, the price must exceed $23.50, the strike plus the premium, to make a profit before fees and interest. A smaller rise can still leave a loss.
Comparing the risks
The purchased calls cannot lose more than the premium paid for them, excluding fees. That still allows a loss of 100% of the option budget. The limit belongs to the option purchase; selling options creates a different set of obligations and risks.
For futures, the smaller margin can make a given profit look very large as a percentage. But that percentage does not show the full amount at risk or the cash that may be needed later. Compare the position size, possible cash losses, and available funds as well as the initial payment.
A smaller initial payment makes a larger position possible. It does not make the forecast more reliable or reduce the loss on that position.
← Previous: Hedging: Fix the Price or Buy Protection · Next: Arbitrage and Consistent Prices →