## Speculating - Profit/Loss Calculations For Speculative Trades

Of the 120 questions on the Series 3 exam, you can expect around 16 on speculating in futures, with an emphasis on speculation in financial markets.**Profit/loss Calculations For Speculative Trades, Including Spreads**

We have focused up to now on hedging, the process by which parties with a direct interest in buying or selling the underlying commodity give up potential financial windfalls in order to ensure they won't face catastrophic losses. The other side of the equation, though, is *speculation*, assuming the risk that the hedgers want to get rid of and trading with the objective of achieving profits through the successful anticipation of price movements.

Speculation is often unfairly maligned. Speculators provide liquidity to the market; without speculating, there can be no hedging. By taking positions opposite the hedgers, speculators act in effect as insurers. The money the hedgers indirectly "pay" speculators is essentially a premium that guarantees against losses in the event of extreme price movements. Market risk and volatility are exponentially greater in thin markets where there is a dearth of speculators and hedgers resulting in light trading volume and greater illiquidity.**Gross Profit on Speculative Trades**

As discussed in the preceding chapter, a great deal of futures volume takes the form of spreads. We will revisit spread profits momentarily, but first we need to understand the dynamics behind an uncovered example so that we can also understand those behind each individual leg of the spread.

Fortunately, computing the profit or loss of an uncovered position (you might hear it called "outright" or "naked") is straightforward, once one understand the market dynamics.

In an interest rate future, the price of the contract and the direction of interest rate movements are inversely correlated. As interest rates go up, the prices of interest rate futures go down. As interest rates go down, the prices of interest rate futures go up. This price dynamic derives from the relationship between bonds and interest rates. These contracts are available for short- and long-term debt obligations.

Suppose it is January 30 and a speculator expects U.S. short-term interest rates to decline pursuant to a meeting of The Federal Reserve Board the following day, and that the rest of the developed economies' central banks would follow suit. The speculator would go on the Chicago Mercantile Exchange (CME) and buy 100 eurodollar March futures contracts at $94.6475. The price is derived by subtracting the yield from 100. Therefore, 100-5.355 = 94.6475. These are contracts on short-term dollar denominated time deposits at banks outside of the United States. The way the CME structures its contracts, an investor will gain or lose $25 per basis point (1/100th of one percent) as the contract value changes as it trades. If the Fed drives rates down and the other central banks concur, then the futures contract price would go up, say to $94.650, or 25 bps. If the investor sold the contract on February 4, then she would make a profit of $625 per contract ($25/bp x 25bp), or a total of $62,500. Her speculation would be successful.

If, however, she guessed wrong and short-term interest rates rose slightly, then the March eurodollar price could decline to $94.6420, or 55 bps. Then her speculation would be unsuccessful and she would lose $1,375 per contract (55 bps x $25), or $137,500 for 100 contracts.

Speculators, then, use spreads for essentially the same purpose as hedgers – to forego some upside potential to guard against downside disaster. The only difference is that the risk management is the goal and small gains a mere possibility for the hedger. For the speculator, by contrast, gains are the goal and risk management a strategy to achieve it.

**LOOK OUT!**

As with hedgers' positions, there can be inter-commodity or inter-exchange spreads, but the Series 3 exam typically has tested on the intra-commodity "calendar" spreads. As we learned in Chapter 7, these are for contracts with the same underlying commodity, but with different delivery dates.

So let us look at a spread from the point of view of the speculator we just met trading eurodollar contracts on the CME. Let's say she, in addition to buying those 100 March contracts for $94.6475, sells 50 June contracts for $94.6485. She then has 50 uncovered contracts and 50 hedged contracts. The basis (recall from the preceding chapter) is -10 bps.

If she's right and interest rates move down, then she makes $31,250 on her uncovered position (contract price goes up by 25 bps; same math as above, but with 50 contracts rather than 100). As for her covered position, let's assume that the June contracts go up to $94.6495. The basis narrows from -10 bps ($94.6475 - $94.6485) to -5 bps ($94.6500 - 94.6495). As a result, the hedged position would lose -$6,250 (5 bps x $25 x 50 contracts). Her net profit, then, would be $25,000 ($31,250 - $6,250). Remember, this compares with a gain of $62,500 from a completely uncovered position. The spread prevented her from realizing $37,500 ($62,500 - $25,000) in profit.

If she is wrong and interest rates move up, then she loses $68,750 (contract price goes down by 55 bps; same math as above, but with 50 contracts rather than 100). As for her covered position, let us assume that the June contracts go down to $94.6470. The basis widens from negative 10 bps ($94.6475 - $94.6485) to 50 bps ($94.6420 - $94.6470). As a result, the hedged position would gain $62,500 (50 bps x $25 x 50 contracts). Her net loss would be -$6,250 (negative$68,750 + $62,500). This compares with a loss of -$137,500 from a completely uncovered position. The spread prevented her from realizing -$131,250 (-$137,500 + $6,250) in losses.

The question this hypothetical investor must ask herself is this: Is it worth losing the potential to make $37,500 in gains to prevent -$131,250 in loss? Although the answer seems obvious, let us remember that this is a very simple example. There are innumerable other scenarios in which contract prices rise and fall and bases widen and narrow. Determining how much of the position to hedge is a strategic decision that the client makes and gives to her trader to execute. Effect Of Commissions On Gross Profits