Your money: the art of speculative trading and its tools

By Sunil K Parameswaran

Speculators are calculated risk takers. If they sense that a product is going to increase in value, we call them bullish speculators, while those who believe that a product will lose value are called bearish speculators. Despite the fact that in today’s Internet-dominated world, everyone receives the same information, and at the same time, not all economic agents treat information in the same way.

This is why not everyone is a bull and not everyone is a bear. Before the Internet revolution, some had inside information, while others got it before their contemporaries, giving them a competitive advantage. Despite the information imbalance, even then some traders were bullish while others were bearish.

Buy low and sell high
In the stock market, bulls take long positions in anticipation of rising prices. Their philosophy is to buy low and sell high. The bears are taking short positions, in anticipation of the price drop. Eventually, one of them will be 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 can sell bonds short, because if rates rise, bond prices will fall. Bears will buy bonds because if rates go down bond prices will go up. Bulls and bears can also speculate using forward rate agreements or FRAs. An optimistic trader on interest rates will buy an FRA because he will get a surge if rates go up. On the other hand, a bearish interest rate trader will sell an FRA, as he will get a surge if the rates fall.

Futures contracts
Derivatives are also used by speculators. Traders who are optimistic about the stock market can be long on stock futures. If spot prices go up, futures prices will also rise and long positions will make a profit. Those who are bearish in the stock market can be sellers of stock futures. If spot prices go down, futures prices will also go down and shorts will make a profit.

Traders who are optimistic about interest rates may be short on Eurodollar futures, federal funds futures, or Treasury bond futures, while bearish ones may be long on contracts. futures on Eurodollars, futures on federal funds or futures on Treasury bonds.

Options are also speculative tools. Bulls in the stock market will be long on calls or short on puts. If stock prices rise, call options can be exercised at a profit. In such situations, the puts will not be exercised and the shorts will retain the premium. Likewise, bears will be long on put options or short on calls. If prices fall, put holders can cash out at a profit. In such situations, calls will not be exercised and shorts may retain the premium received initially. While put options are characterized by an upper limit and a lower limit on profits, due to the limited liability feature of the securities, short positions in call options can lead to very high losses, as the prices of assets have no upper limit.

Speculators play a key role in the stock, bond, derivatives and forex markets. These markets will not have adequate liquidity if participation is limited to hedging operators only.

The author is CEO of Tarheel Consultancy Services