Forward and futures contracts can be used for speculative purposes, just like any other item that can be bought and sold at different times and at different prices.

For example, suppose a speculator believes that gold is going to rise from its current price of $400 per ounce to $450 per ounce. The speculator could buy the gold outright by purchasing $450 ounces (the size of one contract) for $40,000 in the spot market. If the price does increase to $450 per ounce, a profit of $5,000 is earned. This represents a return of 12.5% on the investment:

Alternatively. the speculator could enter into a 9-month futures contract for 100 ounces of gold. If this contract were priced at $415 and the spot price of gold were to rise quickly to $450 per ounce. the contract might rise to a price of $465. By "buying" the futures contract at $415 and closing it out at $465. the same $5,000 profit is obtained:

If only a $2,500 margin deposit were needed to enter into this contract, the $5,000 profit would represent a 200% return on this cash deposit in the minds of some speculators.

However, this exaggerates the true rate of return; because of the daily settlement requirements of a futures contract, the speculator actually has much more at risk than the initial margin requirement. The ratio of the profit to the amount of funds that were potentially at risk, rather than the ratio of the profit to the cash that was put up as a "security deposit," is the correct way to measure his or her return on investment.

Forward contracts can also be used to accomplish the same objective. For example, assume that the speculator decided to buy 100 ounces of gold, 9 months forward, at a forward contract price of $415 per ounce. If the price of gold quickly rose to $450 per ounce, and the value of the forward contract also rose by $50 to $465, the speculator would have an unrealized "paper" profit of the same $5,000:

However, unlike futures contracts that are liquid and can be closed out at any time before settlement, forward contracts are illiquid and, therefore, might have to be held until settlement day. Therefore, in order to "lock in" the $5,000 profit on the forward contract, it might be necessary for the holder of the long position in the contract to enter into another "offsetting" forward contract by selling 100 ounces of gold forward (settling on the same day as the contract that is held long) at a forward contract price of $465.

Being long and short forward contracts for 100 ounces of gold that settle on the same day effectively means that the speculator has locked in the $5,000 profit, regardless of what the spot price of gold happens to be at the time the two contracts expire. However, this profit will not be realized until the two contracts are settled. At that time, the speculator must pay $41,500 to buy 100 ounces of gold at $415 per ounce, as specified by the initial forward contract in which he or she had a long position; simultaneously, the speculator will deliver the 100 ounces of gold and receive $46,500 as per the second forward contract in which he or she held a short position. Because the $5,000 short-term profit cannot be realized for 9 months (settlement day for the two contracts), the net combined value of these forward contracts is the present value of the $5,000 to be received when they expire. With settlement in 9 months, if the risk-free rate is assumed to be 5%, the value of the "covered" original forward agreement is:

This represents a discount of $180.72 from the value of a comparable futures contract, which could be realized immediately by simply "selling" it in the futures market. It would appear, therefore, that the value of forward contracts should be less than that of comparable futures contracts because they are less liquid and expose the counterparties to more credit risk. However, these unfavorable factors are offset by the fact that forward contracts do not require the counter-parties to make margin or mark-to-market deposits, and they may receive slightly better tax treatment from a timing perspective. Empirical studies indicate that price differentials between comparable forward and futures contracts typically are negligible, suggesting that the advantages and disadvantages between forward and futures contracts are largely offsetting.

Option speculate

To .speculate by buying the option at one price and selling it for another, in the hopes of making a profit. Because the value of an option is based on the difference between the spot price of the underlying asset and the strike price of the option, option prices can be highly volatile. Furthermore, they are relatively low priced, so that small changes in the price of the underlying relative to a fixed strike price, can produce substantial changes in the return on the

amount invested in the option. Speculators like the potential for high returns on small investment requirements.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/futures-contracts-used-for-speculative-purposes.php


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