Traders in derivatives markets

Hedgers

These are the investors who enter the derivative market to reduce their risk or hedge their risk. In fact, hedging is the biggest motive that drives investors to the derivative market. The option route is preferred by the hedgers to reduce their risks.

Advantages of Hedging

• Futures and options are very good short-term risk-minimizing strategy for long-term traders and investors.
• Hedging tools can also be used for locking the profit.
• Hedging enables traders to survive hard market periods.
• Successful hedging gives the trader protection against commodity price changes, inflation, currency exchange rate changes, interest rate changes, etc.
• Hedging can also save time as the long-term trader is not required to monitor/adjust his portfolio with daily market volatility.
• Hedging using options provide the trader an opportunity to practice complex options trading strategies to maximize his return.

Disadvantages of Hedging

• Hedging involves cost that can eat up the profit.
• Risk and reward are often proportional to one other; thus reducing risk means reducing profits.
• For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow.
• If the market is performing well or moving sidewise, then hedging offer little benefits.
• Trading of options or futures often demand higher account requirements like more capital or balance.
• Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.

Speculators

It is the most common market activity in any financial market. This basically involves betting against the future price movement and taking positions accordingly. It is a risky activity involving buying the underlying asset and then betting on its price. Earning a big profit is the driving force for speculative activities.

For example, an investor expects the price of a share to drop going ahead. Thus, to profit from this, the investor will short sell the share now and buy later when the price drops.

Advantages of Speculation:

• Liquidity, mobility and price continuity. It makes the market broad-based.
• It makes the price uniform, stable and minimizes the risk of price fluctuations.
• Speculation enables diversion of savings and flow of funds into productive channels.
• Speculators acts as an insurer by providing price insurance or hedging services.
• Speculation is responsible for rational and optimum utilization of scarce natural resources.
• Speculation provides the needed liquidity and marketability to securities so that savings can be converted into investment and capital investment is made easy and smooth.

Disadvantages of Speculation:

• A speculator, by virtue of his ability can influence the prices of securities in the market. This manipulation may not be healthy.
• Speculation facilitates wash sales wherein one fictitious dealings are carried out by one broker to another at artificially created higher prices. This misleads the other brokers.
• Speculator gives different orders to different brokers. Some for buying and some for selling. This stirs the market and the markets price appears what is predetermined by the speculator.
• Bulls monopolise the supply and bears must deliver within a certain period or submit to ruin.

Arbitrageurs

Arbitrage is also a profit-making activity by taking advantage of the price volatility in the different financial markets. Arbitrageurs earn a profit using the price difference resulting in investment between the two markets. Or, we can say they buy an asset at less price in one market and sell it in another at a higher price.

Arbitrage Advantages

• The biggest benefit of doing arbitrage is that the risk element is next to nil, it can better understood with the help of an example, if a multinational company is listed in stock markets of New York and London and in New York market it trade at $100 and in London market it trades at € 160 and exchange rate is $1 = €2 than ideally it should trade in London markets at €200. Now a person thinking of doing arbitrage would sell stock in New York market and buy the same stock in London market and thus he or she would be able to make risk-less profit.
• Arbitrage helps in keeping the price of securities across the markets more or less same and therefore it help in better price discovery of an asset and also put an end to price variances in securities across various markets.
• It helps in making the financial markets more efficient because imagine if there were no arbitrageurs than stocks would have kept trading at different prices in different markets leading to speculation by few individuals which would have damaged the real investors’ confidence in stock market.

Arbitrage Disadvantages

• Many individuals only into take into account the price aspect and they ignore the transactions costs and taxes associated with buying and selling of asset which in turn results in wrong estimation of profits and may even lead to loss if price difference is not much.
• In real life there are not many arbitrage opportunities and even if there are then in order to make profit put of such situations you need to have latest technology in order to take positions quickly and also expertise to make such transactions which only few people possess.
• One requires lot of money in order to do arbitrage, it is not as if you have $2000 then you can do it rather one need to have much more money in order to do a profitable arbitrage.

Margin traders

Another derivative market participant is margin traders. The margin is the initial deposit that an investor makes at the time of entering into a contract.

Benefits of Margin Trading

Increased Buying Power

The most obvious benefit of margin trading is that it increases an investor’s buying power. If your brokerage lets you use the largest amount of margin allowed by law, it effectively doubles your buying power.

Diversification

Margin gives investors more buying power, which means they can purchase more different securities, such as stocks and bonds, in their portfolios.

For investors who don’t want to use mutual funds or ETFs, it can be difficult to build a diversified portfolio, especially if you don’t have a large amount of money to invest.

Margin can increase the amount of money you can use to buy stocks and bonds, making it easier to spread your investments out and buy a variety of securities, diversifying your portfolio.

Higher Potential Returns

Increased buying power gives you the chance to buy more securities than you could otherwise afford. The more securities you own, the greater your potential profit if those securities gain value.

Drawbacks of Margin Trading

Higher Risk

Borrowing money for almost any purpose is risky. You have to pay back the loan eventually.

Borrowing money to invest is doubly risky. There’s no guarantee that an investment will succeed. Whether the securities you buy gain or lose value, you will have to pay back the amount that you borrowed.

If you use margin to buy stocks that fall in price, you will lose more money than you would have lost if you didn’t use margin. In some cases, you could wind up losing more money than was put into your portfolio.

Maintenance Requirements

Brokerages that offer margin typically have two margin requirements: one for opening a new position and one for maintaining an existing position.

For example, a brokerage may let you open a new position with 50% margin. Effectively, you can borrow up to the amount of money you’ve put into your portfolio so that half of the purchase comes from your own funds and half is borrowed from the brokerage.

Once you open a position by buying shares, the portfolio has to maintain enough value to meet the brokerage’s maintenance margin requirement.

Interest

Borrowing money isn’t free. Almost every loan means paying interest, and margin is no different. When you use margin to invest, you have to pay interest based on the amount of money that you’re borrowing.

Each brokerage can set its margin interest rates. Some charge the same rates regardless of how much you borrow while others adjust the rate as you borrow more often lowering the rate the more you borrow.

Investors need to account for the cost of borrowing money to invest on margin before borrowing money. The interest charges reduce gains on successful investments and increase losses from poor-performing investments.