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that is the thing you dont see... when you are trying to offset or hedge a risk ... that risk is not on both sides... you are trying to hedge against a specific risk that would result in a loss on both cases..
if you have an overage on inventory and you sell that inventory, you want to hedge against prices going down... that is why futures exist for grains for example.. farmers try to lock the price before delivery to offset their production risks..
if you need inventory and need to maintain prices at a certain level given a certain production requirement.. you want to hedge against prices going up and as such lock in your raw material costs today...
in the purist sense I see what you are stating, however, one hedges to offset a risk of something on the direction that would create harm to one's bottom line, etc.... not to profit from something, which is what a speculator would do..
Can you help answer these questions from other members on NexusFi?
The farmer is a perfect example. He "locks in" price at the current price and his only risk is the spread between the current contract and the month he bought it.
A true hedge is an exchange of potential profit for reduced risk. In both the case of the farmer and the airline, they've only reduced risk on one side....so I punt. I'll admit that you're correct.
If you buy oil and lock in for November's contract today, and prices go DOWN, then you lost money. You speculated on potential savings (which some smart business people have said "A $ saved is the same as a $ earned on the bottom line."
My whole point is that "speculation" in it's purest sense is supposition and anticipation. Regardless of how it's used. Whether you're a guy who's flipping a condo that's not even built yet and selling the deed at a profit before the floor it's on is even built, or the family that chooses to "hurry up" and buy now because they think home prices are going up, speculation is speculation.
I do concede that buying a futures contract is a form of hedging..... albeit not what I would consider a "true" hedge. A true hedge is when a stock holder owns shares of Boeing and the compeition for the F-22 are coming to an end and rather than try to make a profit, he just wants to lock in his current value, so he longs a corresponding value of stock in Lockheed and then, no matter who wins, he doesn't lose money. He gave up his opportunity for profit in exchange for reduced risk. THAT is a classic hedge your bet (protect your bet) strategy.
I am sorry too @Silvester17 ... didnt meant to hijack the thread... but I believe it was relevant to the original post...
@RM99, I did find the exchange very informative and that lead me to look into the WTI/BRN spread... never cared much about crude, but it is interesting all the variables that that go into pricing a spread from a fundamental perspective.. a lot more than a thought... so I thank you for sparking the discussion and my interest.
If you want to hedge your risk, you need a counterparty. It is not obvious that such a counterparty exists, who is willing to take on your risk. A counterparty only exists if the market is sufficiently liquid or if there is a designated market maker or risk taker, who is willing to make two-sided quotes.
The best way to hedge out risk is to purchase an option, but then you have to pay an insurance fee, which is the option premium. To buy an option you need somebody to underwrite that option, the underwriter is always a speculator, as he speculates that - over a large number of options - the risk will not produce. If you look at AIG, they were engaged in this business, underwriting credit default swaps. What they did not understand is that all their bets were highly correlated, as their value-at-risk models took only into account recent correlations.
If you engage in a futures contract to hedge your risk, you also need a counterparty. In the futures market there is no balance between long and short hedgers, but typically there is a structural gap that cannot be easily bridged without speculators. So speculators are badly needed to create a liquid market place.
Basically the conclusion is:
You cannot hedge without facilitators (speculators).
Now any market place needs some rules and somebody to enforce the rules. Imagine that we have a game of soccer and there are
- no rules (laws and regulation)
- no arbiters (enforcing the rules)
- or arbiters and players that would be allowed change the rules during the game
This is a bit what would follow from the principle of the invisible hand and which as not shown to be an effective policy during the last years. So the problem is setting up the rules. If you want to blame the speculators you just take away one of the two soccer teams and declare the other on winner. I am afraid that there will be no more games.
The problem is not the existence of speculators, but the high volatility which has the potential to destabilize markets.
If crude oil prices are moving up, they are not gamed. There is a growing world population, there is a devaluing dollar due to irresponsible financing policies, there are wars in the Arab region. Politicians are responsible for not regulating the markets, politicians are responsible for budget deficits and failed policies, politicians decide on unnecessary wars. But for politicians it is easy to blame speculators for their own misdoings. It is not the speculators who are printing money. It is not the speculators who are engaged in burning ever more oil products. It is not the speculators, who are engaged in wars in Arab countries.
So if crude is moving up, what is harmful and can be attributed to speculation is not the tendency, but the additional feedback generated and leading to unnecessary price spikes. Too many speculators can contribute to volatility and exacerbate spikes. So the regulator might look for a way to dampen volatility in markets that otherwise work well.
This needs some analysis, where the feedback loops and the unwanted volatility comes from. There are some candidates:
(1) high frequency trading
(2) large participants, such as Amaranth in the natural gas market and Armajaro in the London cocoa market
(3) fear arising from counterparty risk linked to OTC transactions and unknown products such as CDOs
Some participants in the markets try to gain an advantage by changing the rules of the game. This comes at the expense of everybody else and would qualify as moral hazard. This is the soccer player inventing a new type of foul, which is not ruled out and giving him a temporary advantage. These points must be addressed by regulators and arbiters, the 3 points mentioned above can be treated in a similar way
(1) dampen high frequency trading by enforcing a transaction tax (can be minimal) and a prior margin verification
(2) enforce limits on maximum positions sizes
(3) transfer OTC to public exchanges and ban dark pools
Only a regulated market place will allow for an orderly market that performs the functions as expected, including price discovery and fair transactions with a limited risk of failure.
I have a read an interesting little book by Bruce R. Scott, which summarizes some of the basic concepts.
just one thing I can't agree. I would say in most cases it's the other way around. normally the option buyer is the speculator (in an opening transaction of course). if you buy a call option, you speculate the price will go up. and the seller (or writer) wants the premium. if price goes up he (the seller) might have to deliver the underlying, but got premium and probably a profit because of higher strike price. and if price goes down, he still has the premium and therefore a lower price for his underlying instrument. I would call that more risk management than speculation.
and the other thing, what did you have in mind about inventing a new type of foul in a soccer game?
anyway I still believe if there would be no day trading (that part I call gaming) allowed in crude, there would still be enough liquidity for hedging and a lot less volatility and probably a significant lower price as well. now this you can call speculation, but I have no doubt.
Imagine my name is United Airlines and that I want to secure my fuel supplies. I know it is a bad example, because they will mostly hedge with gasoil futures and some gasoline futures to reduce the basis to jet. As an airline operator I want to protect myself against rising fuel prices, and there are two ways of doing this
(a) buying a call option
(b) going long gasoil futures
(a) has the inconvenient that I have to pay an insurance premium - the option premium. Also it is not sure that I will find somebody to underwrite the risk at a reasonable price.
(b) has the inconvenient that fuel prices may go down and that I will lose out on the trade, which cannot happen with an option.
What is important to understand: The option seller is always a speculator. By selling options you cannot hedge anything, it is simply a speculative investment. Now, you can pretend that writing covered calls is no speculation as you already own the underlying. But we all now that a covered call has exactly the same risk profile as a short put, that is a limited upside and a downside only limited by the total loss of the investment in the underlying.
The role of the speculator traditionally has been assumed by banks and funds as well as managed money. These actors were willing to insure the commercials by selling options or acts as a counterparty for trading futures. But if you look at it, the banks, the investment funds and the CTAs managing other people's money are the speculators.
So here is my point: An option seller is always a speculator. An option buyer may be hedging exposure. A put option on a stock index can be used to protect an investment in less liquid stocks. A call option on gasoil can be used to secure future purchases of jet. Selling an option cannot be used for anything. If there were no speculators, options would not exist.
a speculator does not own the underlying instrument. heck that's why he's called a speculator. so in other words, if you write covered calls (option seller), you're not a speculator. of course if you sell naked options, that a different story. but to say a option seller is always a speculator is not true imho.
The fund A holds treasury securities and sells a naked put, while the fund B holds a stock and sells a covered call. If I follow your argument, A is a speculator and B is an investor.
Unfortunately their positions are identical until the options expire. It is a fairy tale that writing covered calls is less risky than writing naked puts. The risk is the same. If you write a covered call, your margin is depositied with stocks, if you write a naked put, it is deposited with treasury securities that the broker holds for you.
The only difference between investors and speculators is the holding time
Both the investor and the speculator want to make money on their investments. A fund switches in and out of liquid securities on behalf of the investors. The fund is speculating with the money of the investors. So it is a machine to transform investors into speculators?
albeit not what I would consider a "true" hedge. A true hedge is when a stock holder owns shares of Boeing and the compeition for the F-22 are coming to an end and rather than try to make a profit, he just wants to lock in his current value, so he longs a corresponding value of stock in Lockheed and then, no matter who wins, he doesn't lose money. He gave up his opportunity for profit in exchange for reduced risk. THAT is a classic hedge your bet (protect your bet) strategy.
