Long speculator

A hedger has something to protect. A speculator does not.

Speculation is trading to make quick profits from price movements. The workbook is blunt about it. Speculators never use the underlying asset for future physical use, because the objective is a quick profit from a change in price.

There are two kinds, and the split is just which way round they go.

A long speculator buys first. He expects the price to rise from the current level.

A short speculator sells first. He expects the price to fall.

The key word in the workbook's definition of the trade is without. A long speculative transaction is a long futures position taken in expectation of a price rise without any corresponding short position in the spot market.

So it is the absence of an exposure that makes it speculation. On the screen, the trade looks exactly like a hedger's long.

The risk is real, and the workbook says so: speculation does not undertake the safety of the initial investment, let alone the return.

The definition. Long speculators are those who buy first and expect the price to increase from the current level. Taking a long position in a commodity futures contract in expectation of an increase in price before the expiry of the contract, without any corresponding short positions in the spot market, is a long speculative transaction. If the futures price rises before expiry the trader profits by squaring off; if it falls, he takes a loss.

The pay-off is linear and symmetric. The workbook's formula is:

Long Pay-off = ST - F

where F is the futures price at which he bought and ST is the spot price at expiry. Its own worked table, for a long at Rs 100, runs the spot at expiry from 50 to 150 in steps of 10 and gives pay-offs from -50 to +50, crossing zero at exactly Rs 100. There is no cap on either side.

He normally never sees the goods. Because speculators participate for trading only and are not end users of the commodity, they typically do not take physical delivery and instead liquidate their positions prior to or upon expiry.

Three sub-species, all of them speculators in the workbook's taxonomy:

Why the market wants him. Hedgers transfer their risk to speculators, and the workbook lists risk transfer as one of the key economic functions of the commodity derivatives market. Hedgers try to avoid risk and protect against price changes; speculators accept risk in an attempt to profit from it. Because commodity derivative contracts are standardised and participation in them can be purely financial, the workbook also treats them as a suitable product for investors diversifying portfolio allocations.

With options instead of futures. The workbook notes that options are a versatile risk-management instrument, usable under rising or declining price scenarios, conservatively or aggressively, and that an option buyer pays a premium for the rights contained in the option. A long view can therefore be expressed by buying a call rather than a future, at the cost of that premium.

Take the workbook's own long futures at Rs 100 and read it as a speculator's position rather than a hedger's.

Now put it on a real contract. Mr Sethuraman buys 1 lot of gold futures — a 1 kilogram contract quoted per 10 grams — at Rs 71,000, purely because he thinks gold will rise. He owns no gold and sells no gold. Contract value: 71,000 x 100 = Rs 71,00,000.

Nothing in either row is offset anywhere else. That is the whole difference from a hedge.

Compare a jeweller who buys the same lot at the same Rs 71,000 because he must buy a kilogram of gold in August. He is naturally short the metal, so his Rs 1,40,000 futures gain is cancelled by paying Rs 1,40,000 more for the physical gold, and his Rs 1,20,000 futures loss is cancelled by paying that much less. His net is roughly nil in both rows.

Same contract, same price, same direction, opposite economics. Mr Sethuraman is a long speculator because there is no second leg.

Chapter 5 (Uses of Commodity Derivatives), section 5.3 on speculation, which names the two types — long speculator and short speculator — before working each one through a futures position. Chapter 3, section 3.8.1, supplies the long pay-off formula and its table, and Chapter 1's participant list supplies the day trader, position trader and market maker subdivisions.

Expect a definition question — long speculators are those who ____ first and expect the price to ____ — buy, and increase. The discriminating question is the one that turns on without any corresponding short position in the spot market, because that phrase is what separates a speculator from a hedger doing the identical trade. Chapter 5's own sample question asks who a described participant is, with speculator as one of the options.

• Long speculator buys first; short speculator sells first. The whole distinction, and it is asked directly.
• What makes it speculation is the missing second leg. The workbook's test is the absence of a corresponding spot position, not the size of the trade or the holding period.
• A long futures position is not automatically speculation. A jeweller who must buy gold later is hedging with the same trade, because he is naturally short the metal.
• Speculators do not usually take delivery. They liquidate prior to or upon expiry, since they are not end users of the commodity.
• Day traders, position traders and market makers are all speculators in this workbook, not separate participant categories. A question listing them as alternatives to speculators is testing that.
• The pay-off is unlimited both ways. Long Pay-off = ST - F has no cap and no floor above zero, unlike a bought option where the loss stops at the premium.
• Speculation risks the capital, not just the return. The workbook's phrasing is that it does not undertake the safety of the initial investment along with the return.
• Do not confuse the long speculator with the arbitrager, who holds two offsetting legs and aims at a riskless profit rather than a directional one.