Apr 18

It seems like whenever a particular market has hurt a bunch of people, and we all know that’s happened lately with a lot of markets and a lot of people, the chorus rises up against that group that surely must have made things worse: speculators.    But amidst the hysteria and hand-wringing, it’s instructive to calmly walk through the scenarios that speculators and their trading counterparties find themselves in as they go about their business.

Merriam-Webster defines “speculate” as:

1 a : to meditate on or ponder a subject : reflect b : to review something idly or casually and often inconclusively
2 : to assume a business risk in hope of gain; especially : to buy or sell in expectation of profiting from market fluctuations

So it seems that to be a speculator, you need to have a view on something.   That’s generally the easy part, in that most people will express a view on just about anything.  Whether it is “correct” is another matter entirely, as is the issue of who decides what “correct” is.   But acting on those meditations and reflections results in the market itself:  two people having different views on the value of some tradable thing, each being willing to swap ownership.

One would hope that even Oxfam and the AFL-CIO would concede that no speculator “speculates” on a regular basis with the intention of losing money over the long term.   From that one truism, we can deduce that rational speculators have every incentive do a lot of reflection, and act only when they think they will be profitable.    So how do they act?

Speculators only garner attention when they displace some other market participant.   After all, if they simply replaced a supposed “non-speculator” at the same market price, who would know, or care?   Yes, there’s an important liquidity-providing role that can’t be understated.    That function rarely receives any attention, except when it’s missing, as in the credit markets of late summer of 2008, with the proverbial “market liquidity has evaporated” sorts of phrases being heard repeatedly.   Mostly, speculators get noticed because they move markets.   Indeed, they often have to.  But when they do, in every case, the person taking the other side of the speculator’s trade is made better off.    Here’s why:

Say two trading counterparties are about to transact on a product, say a barrel of oil, at $85.   The basic tenet of free trade would state that both parties are going to be made better off, in that the buyer of the oil will value the oil more than their cash, and the seller of the oil will prefer the cash.  Why else are these two people trading with each other?  Who knows? Certainly not Oxfam, a labor union, or any member of Congress.   But say a “speculator” suddenly interrupts the proceeding and tells the seller that they will pay $86 for the oil instead.   The seller says to himself, “Well, I was happy to sell it at $85, but I’m even happier to receive $86”.  So, in trader parlance, “done!”.

Why would the speculator “bid up the price” of oil to $86?   Because they’ve meditated, pondered, reflected and otherwise decided that they’re going to be able to sell the oil at something higher than $86, maybe later in the day, tomorrow, next week or next year.  They just want in.  They displace the $85 buyer and become an $86 buyer instead.   The speculator can’t trade without making their counterparty better off than they would have been with their supposedly “non-speculating” alternative.

What about the displaced $85 buyer?  If the speculator was wrong, and oil falls in price, that original $85 buyer has been afforded the opportunity to buy at a lower price.  The speculator’s loss becomes their potential gain.   However, if the speculator is right, the $85 buyer is faced with the reality that they’ll have to pay more — the market is telling them that at least at the moment, what they wanted is more valuable than they originally realized.    Of course, they might say, “no way — it’s not worth it” and walk away.

What about from the sell side?   Say a seller is out there ready to sell oil at $85, but the speculator displaces that seller by selling oil lower, at $84.  The corresponding buyer, who was ready to pay $85, is happy to trade with the speculator instead, because the buyer now has $1 left over.   Why would the speculator sell for less?   Because they’re convinced oil is worth less than $84.   They might even be shorting oil, happy to receive $84 now, believing they can replace that oil later by buying it back at a lower price and pocketing the difference.   What if oil goes up instead?   The speculator loses, and that displaced seller can sell again at a higher price.   If the speculator is right, their capital account increases and to whatever extent they’re consistently right, others may be able to monitor their activity and profit from it as well.

This brings us to the issue of time objectives. Many speculators want to be in and out quickly, while others make long term bets.   In either case, the dollars made or lost are indistinguishable as a form of capital (ignoring inflation and/or currency fluctuation).  So therefore, who’s to say which is more legitimate?   Capital raised through short-term speculation can be immediately re-deployed into a long term investment, or consumption of any kind.  In any case, the provider of the investment or consumable doesn’t care whether the requisite capital was raised over the short or long term.  “Sorry ma’am, we can’t accept your down payment on your new Prius.  We understand you made that money speculating.”  Not going to happen.

But short-term speculators enjoy a special distinction:   Remember that to get anything done the speculator has to be aggressive and has to be willing to act at the existing price, or establish a better price.   Therefore, short-term speculators are the market. They provide the liquidity that any market needs to work better, or at all.

How about people who would seek to reduce the activity of speculators, whether by high margin requirements, restrictions on short-selling, or other kinds of regulations?     Are the “non-speculating” actors in the market (however one would determine such a thing) somehow more informed, or in some way representative of a more legitimate type of market participant?   Do they make more legitimate or “better” prices?   We just saw that it was in fact the speculator, in search of a profit, that actually made a better price for their counterparty.   Do the would-be regulators know more about how the market should really behave than the people who are willing to act on their pondering?    For all we know some of the regulators might in fact be formerly failing speculators.

What about those speculators that seemingly churn each other and send a market consistently higher or lower over a protracted period of time, supposedly against the “true value” of the product?   Again, who’s to say what the “true value” is?   If someone is so convinced that the market is “out of whack” with the “true value” they can speculate themselves and profit from their truth.   In the meantime, if there are market participants who can’t be bothered with all of the fluctuations, products exist to smooth those out, such as home heating oil futures. And where they don’t, maybe they should:   Retail monthly or quarterly gasoline futures, anyone?

As the saying goes, “where there’s smoke there’s fire”.   Again, in the case of speculators, the profit motive ensures that they’re not just throwing money around willy-nilly.   So if for some reason a market is being “bid up” (or down), at least in part by speculators, one can bet that the more aggressive participants are acting on what they believe is better information.  In other words, they have to possess a more accurate view of where the “true value” of the traded product lies, at least for their time period of interest.

Indeed, if over time particular speculators develop reputations for being right more often than not, their sudden activity in a market can move the market.   Just ask any Chicago bond future trader about Tom Baldwin.   And behind every successful speculator is a grumbling displaced participant who is unhappy that they now have to provide a better value to their counterparty. Conversely, if over time a particular speculator is consistently wrong, the market will dispassionately drain their capital.   There is no need to regulate them because provided they are not bailed out, the market will regulate them out of existence without mercy.

But to a Congress that is bent on command and control, I’m just speculating that none of this will make any sense.

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