Your Money: The art of speculative trading and its tools

November 08, 2021 1:00 AM

Speculators play a key role on stock, bond, derivative and foreign exchange markets

In the stock markets, bulls take long positions, in anticipation of rising prices. Their philosophy is buy low and sell high. Bears take short positions, in anticipation of falling prices. Eventually one of them will be proved right, while the other will have to accept a loss.In the stock markets, bulls take long positions, in anticipation of rising prices. Their philosophy is buy low and sell high. Bears take short positions, in anticipation of falling prices. Eventually one of them will be proved right, while the other will have to accept a loss.

By Sunil K Parameswaran

Speculators are calculated risk takers. If they feel that a product will rise in value we call them bullish speculators, whereas those who feel that a product will decline in value are called bearish speculators. Despite the fact that in today’s internet driven world, everyone gets the same information, and at the same point in time, all economic agents do not process information in an identical fashion.

That is why everyone is not a bull nor is everyone a bear. Before the internet revolution, some had privileged information, while others were getting it before their contemporaries, giving them a competitive advantage. The information imbalance notwithstanding, even then some traders were bulls while others were bears.

Buy low and sell high
In the stock markets, bulls take long positions, in anticipation of rising prices. Their philosophy is buy low and sell high. Bears take short positions, in anticipation of falling prices. Eventually one of them will be proved right, while the other will have to accept a loss.

In the bond market bulls are those who expect interest rates to rise, while bears expect interest rates to fall. Bulls may short bonds, because if rates rise, bond prices will fall. Bears will buy bonds, because if rates fall, bond prices will rise. Bulls and bears may also speculate using forward rate agreements or FRAs. A trader who is bullish on interest rates will buy an FRA, for he will get an inflow if rates rise. On the other hand, a trader who is bearish on interest rates will sell an FRA, for he will get an inflow if rates fall.

Equity futures
Derivatives are also used by speculators. Traders who are bullish about the stock market may go long in equity futures. If spot prices go up, so will futures prices, and the longs will make a profit. Those who are bearish about the stock market may go short in equity futures. If spot prices decline, so will futures prices, and the shorts will make a profit.

Traders who are bullish about interest rates may go short in Eurodollar futures, Federal Funds futures, or Treasury bond futures, whereas those who are bearish, may go long in Eurodollar futures, Federal Funds futures, or Treasury bond futures.

Options are also speculative tools. Bulls in the stock market will go long in call options or short in put options. If stock prices rise the calls can be exercised at a profit. In such situations, puts will not be exercised and the shorts will retain the premium. Similarly bears will go long in puts or short in calls. If prices decline, put holders can cash out with a profit. In such situations, calls will not be exercised and the shorts can retain the premium received at the outset. While puts are characterised by an upper bound and a lower bound on profits, due to the limited liability feature of securities, short positions in calls can lead to very high losses, because asset prices do not have an upper bound.

Speculators play a key role on stock, bond, derivative and foreign exchange markets. These markets will not have adequate liquidity if participation is restricted to hedgers alone.

The writer is CEO, Tarheel Consultancy Services

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