While all of these derivatives, options, forwards, futures or swaps provide the risk reduction or hedging function that is attractive to many individuals, they also attract millions of speculators who are interested in something quite different all together, providing yet another complex layer to these investments. This is because, unlike those seeking to use derivatives for hedging or risk reduction, speculators bet on price movements seeking immediate gain, which exposes them to considerable risks. The results can sometimes magnify into massive profits, or leave speculators sustaining terrible losses. Some think of speculators as essentially being gamblers who literally create risky situations for themselves that did not exist before. But speculation on derivative markets is quite different from betting on, let's say, the roulette wheel or rolling the dice. Whether you agree with this criticism or not, here is an example that highlights the appeal of speculative investing in derivative markets. Say you believe gold is undervalued, and you think prices will rise. You have $5,000 to invest, which is enough to purchase either five ounces of gold, assuming $1,000 an ounce, or two futures contracts that each hold 100 ounces of gold. 100 ounces of gold multiplied by $1,000 equals a value of $100,000 ounces per contract, times two contracts that you've purchased. And now, you're speculating with $200,000.00 worth of gold. Despite it's attractiveness, you decide to play it safe and purchase five ounces of gold and enjoy your less risky choice. Now, five months go by. Gold goes up by 20% which, incidentally, is exactly what happened between January and May of 2016. Your five ounces of gold are now worth $6,000. That's a $1,000 profit representing 20% of your $5,000 investment. But had you bought the two futures contracts, these would now be worth $240,000. That's 20% up on $200,000, which gives you a $40,000 profit. And that represents an 800% rate of return on investing the same $5,000. For some, the speculative appeal of $40,000 profit makes the $1,000 profit pale in comparison. And this potential outcome is what attracts speculators, despite the risk that they could lose their entire investment, which would happen if gold prices did not change or if they decreased by the time the contract had ended. Comparatively, if you simply purchased gold, there is no expiry date on that investment. Thus, you can continue to own your investment, thereby retaining some value and keeping hope alive. Take a look at the additional examples that we've provided to help clarify the mechanics of investing in futures, maintaining margins, and clearing your account. Now, as mentioned earlier, our general perception of speculation is probably negative. That's because the media portrays that speculation to be associated with actions that have to do with market manipulation or market turbulence. In fact, speculation is actually quite important to keeping markets healthy. Consider governments who want to manipulate their currencies to gain competitive advantages. For example, a weak currency boosts exports and creates trade surpluses which can then be used to increase domestic production and generate employment. Governments can sell tons of its currency in the foreign exchange markets to devalue it, though it may have linked or pegged its official rate with a strong currency. The U.S. government, for example, has consistently accused China for such behavior to deliberately devalue the Yuan. However, it's a lot more complicated as this sort of currency manipulation also involves a whole set of other variables, including interest and inflation rates, the level of government debt, the movement of other major currencies, and all sorts other factors which will also bear on this exchange rate. Anyway, speculators take positions to take advantage of price differences that smooth out what would otherwise be violent price changes. It is much harder to pull off large scale manipulation with more rather than fewer speculators. And so we need them. And the same can be said about preventing shortages. If the price of a scarce commodity, like oil, is expected to change for any reason, futures contracts will help us to preemptively resolve unwanted surpluses and shortages.
