In Defense of Speculators, Part I: Options Traders

American politicians from all across the ideological spectrum are beginning to blame speculators for our collective woes.

John McCain and Barack Obama both blame speculators for high oil prices—never mind the fact that these traders are only reacting to the threat of U.S. aggression against Iran when they bid up the price of crude. McCain and Obama, along with virtually every other national political figure, often portray these speculators as nothing more than parasites who add nothing of value to the economy.

In fact, speculators provide a wonderful service to the world by stockpiling surpluses when prices are low and selling those surpluses when prices are high. This, on net, makes prices higher than they would otherwise be when supplies are high, but it also makes prices lower than they would otherwise be when supplies are low. In fact, if speculators did not stockpile during the good times, there might not be any of the commodity in question when bad times came around.

But do speculators get recognized for their contributions to the world? No. Instead, they’re vilified and scapegoated because people don’t understand what it is that speculators do. This is an age-old human trait known as bigotry, and it is no more acceptable when applied to speculators than it is when applied to racial or ethnic groups. The key to overcoming prejudice is understanding. So with this article, we will look at the most basic of all speculators: the options trader.

“Speculating” on Options

There are options for nearly every type of financial security: commodities, foreign currencies, market indices, etc. But the easiest way to understand options is by viewing them as applied to the financial instrument most readers are familiar with: common stocks.

A call option gives the holder the right, but not the obligation, to buy a given stock at a given price on or before a given day. For example, AMZN 80 Oct Call gives the holder the right to buy 100 shares of Amazon stock at $80 on or before the third Friday in October. With Amazon trading at $76.95 as of August 7, how much would you be willing to pay for that right? Well, with two months and one week to go before expiration, you could have bought it for $5 per share ($500 for a contract of 100 shares).

Now if you bought this option for $500, there would obviously be no point in exercising it right away. After all, it would make no sense to buy shares for $80 (as your contract would allow you to do) when the market price of the stock was $76.95. But imagine the stock went to $90. Now you could buy shares for $80, even though the market price was $90, and turn around and sell them for the market price of $90. Or, more realistically, you could sell your options contract, which would have appreciated in value along with the stock, thus saving you from the burdensome expense of having to actually buy the shares of stock in order to make your profit.

Is Your Grandma a Speculator?

On the other side of the trade is the call writer. This person typically owns the shares on which he “writes” the call and agrees to sell them if the contract he writes is exercised. For every call buyer there is a call writer. Writing so-called covered calls (which means the writer owns the shares of the underlying stock) is a technique used by many retirees to earn income on the stocks they own.

For example, if your grandma owned 1,000 shares of Microsoft, which was trading at $27.39 as of August 7, then she could write ten covered call contracts agreeing to sell the stock for $32.50 per share any time between now and January 16, 2009, and receive a $0.53 per-share premium—$530. If Microsoft didn’t reach $32.50 in that time, the call she wrote would expire worthless, and she’d keep the $530. If Microsoft did reach or exceed $32.50 per share, she would be obligated to sell at that price, but she’d still keep the $530. It’s a win-win situation.

The speculator in these cases is the call buyer. He’s “speculating” that the stocks will go up, and rather than buying actual shares, he’s leveraging his bet by buying calls, which allow him to control many more shares for a fraction of the price. In response, conservative investors—like your grandma—are able to generate income on their portfolios.

How Speculators Make the World a Better Place

Who loses out here? No one. Who gains? Not only the speculator and your grandma but also the world as a whole. The existence of options trading makes the stock market more liquid, reduces the spread between the bid and ask prices of stocks (thus “cutting out the middle man”) and makes capital easier to raise. The entire world benefits.

Oil speculators provide a similar service. So before you castigate someone you don’t understand, make an effort to understand exactly what it is that they do. After all, you wouldn’t want to sound like a politician, would you?

For more information about the Stop Excessive Energy Speculation Act, the newest act proposed in Congress on controlling oil speculation, read G.L.C.’s post “The Government’s Latest Efforts to Rein in Oil Speculators.”

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