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Trading and Speculation

The role of the Speculator

What is professional speculation?

We think you should know exactly what you are doing, where your place is in the grand scheme of things, and what your social purpose is.

1. What is Speculation?

What is speculation? There are various definitions: " engagement in a risky business transactions in chance of quick or considerable profit"; "engagement in business transactions in solving considerable risk but offering the chance of large gains". These are dictionary definitions, which pose the emphasis on risk and potential reward. Another definition, by an agricultural economist, Holbrook Working, is "the holding of a net long or net short position for gain, and not as a normal incident to operating a producing, merchandising, or processing business".

The commercial meaning of "speculation" was undoubtedly derived from earlier use of the verb speculate in the sense of observe (the meaning of its Latin root, speculari), hence to try to see, or try to understand. In that sense of the word, we speculate on the nature of the universe, on the reasons for a person's actions, or on the probable consequences of a given situation. The verb implies uncertainty, coupled with some reasonable basis for an opinion regarding the subject concerning which we speculate, or meditate. Presumably the present commercial use of the term originated from frequent references to speculation (in the sense of meditation) about future commercial events. In time "speculate" came to mean the actions taken on the basis of such meditation rather than the meditation itself.

However the term has also been downgraded, and used as in a "speculative venture" and have people understand that by speculative we mean risky – a meaning far removed from the original meaning of speculate. Actually, in the past few years (especially after the 2007 Lehman collapse and the following recession) the positive/negative debate on speculation has taken a turn for the worse once again. If there's one thing that you must know here and now, it's that there has always been and there always will be a debate on the merits and interpretations of speculation.

Here are some headlines that illustrate the case at hand:

The basic concern is that speculation generated unwarranted moves in food and other commodity prices. But who are speculators? Take a good look in the mirror: you'll see a "spec" staring back at you.

Source: CME

Now confront these facts with the populist views on futures markets and speculation:

2. Speculation: Good or Bad?

Speculation has been a point of contention throughout the history of markets so the current controversy is nothing new. The long battle over speculation that played out over the first century of futures trading in the U.S., stretching roughly from 1870 to 1970, actually threatened the industry with extinction. Futures markets were viewed by many as mere gambling dens filled with manipulative speculators.

There is an important and largely untold story about the role of three relatively obscure agricultural economists in changing this perception. Holbrook Working, Roger Gray and Tom Hieronymus stepped into the long-running public fray over speculation and futures markets and brick-by-brick built the foundation for understanding the economic functions of these markets. Over the course of nearly six decades they showed the world how futures markets worked, guided policy debates, and led the public to a more informed position about the value of these markets. In doing so, they played a key role in "saving" futures markets. There are some key lessons from past speculation controversies and how leaders like Working, Gray, and Hieronymus responded that can applied to the present one, which is largely traced to the price spikes of 2007-08.

Those lessons are:

Holbrook Working also said that "Futures prices tend to be highly reliable estimates of what should be expected on the basis of contemporary available information concerning present and probable future demand and supply; price changes are mainly appropriate market responses to changes in information on supply and demand". Thus creating the basis for the usefulness of speculation.

To cite some more recent authors that have approached the debate, Ingo Pies in "The Morality of Speculating on Agricultural Commodities" 2012 said that "the empirical findings are what is decisive: the vast majority of all studies and a preponderant share of these new, increasingly effective studies arrived at the conclusion that index speculation follows after (and therefore does not cause/precede) a rise in prices. In the case at hand, the civil society organizations clearly issued a false alarm and made an incorrect diagnosis. And so, the recommended therapy is inappropriate."

And on the back of such comments, Deutsche Bank returned to commodities speculation. Goes to show that the argument is quite convincing if a top-tier investment bank find it appropriate.

3. Usefulness of Speculation

"People who argue that speculation is destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when the currency (commodity) is low in price and buy when it is high." Milton Friedman, Essays in Positive Economics

Friedman basically said that speculators who continually lose money by buying high and selling low (which would increase volatility and be destabilizing) will be forced to leave the market eventually, and only rational speculators - those who will actually help to stabilize prices - will survive. Let's proceed with an example that touches us all: the Oil Market. A speculator in the oil market, for example, would buy some quantity of oil contracts at a given price with the expectation that he will sell these contracts in the future at a sufficiently higher prices than he paid to justify interest carrying costs, and other costs of holding these contracts. If successful he makes a profit. At the same time, however, he would serve two socially useful functions:

a) he would incrementally raise the demand for oil now, and thereby raise present oil prices. When he sells his long contracts in the future he would incrementally raise the supply of future oil, and hence lower future oil prices. In this way, he would contribute to greater stability of oil prices over time.

b) speculators also provide futures, or hedging, markets for oil and other producers of commodities and assets. These producers may not want to bear the risk of what future spot prices will be, so they may contract in futures markets to sell their future outputs at market-determined prices. They sell in part to speculators who hope to profit from any difference between the prices in futures markets and actual future prices.

When prices of oil, natural gas, copper, food, and other commodities rose sharply from 2004 to 2008, oil reached a peak of over $145 a barrel. Politicians, the media, and many others pointed their fingers at speculators for the severe price increases. Of course, no one credited those same specs when prices fell during following years, because "obviously" the worldwide recession was the main cause of this steep fall in commodity prices. It should have been equally "obvious" that booming world demand by China, the US, and other countries mainly explained the run up in commodity prices during the boom years prior to the world recession. As the world economy continues its recovery from the crisis, commodity prices will continue to rise again, with or without speculators.

Source: CME

Some companies, like Kellogg and Heinz, have managed to offset the higher ingredient costs and post robust profits by using shrewd commodity hedges and by raising prices without losing many customers. They also benefited from a trend of consumers eating out less and buying more groceries.That's not to say every food company will flourish while their input costs are high. However, it does underscore the part our markets play in managing the price companies pay for grain and other prime materials, allowing them to pass fewer costs on to consumers.

The role of the "spec" is often brought into question when price volatility increases for commodities such as wheat, crude, oil and corn. The fact is that the participation of "specs" adds liquidity to the markets. This liquidity helps to moderate price swings and closes the gap between bids to buy and offers to sell. The trading activity of speculators anticipates or warns about shortages or surpluses. Prices are determined by a number of factors such as weather, global demand, government policy, energy costs and currency fluctuations. So those that decide to partake in these markets need to be informed and keep in touch with the ever-evolving global economic situation. That's not something that just anybody can or would like to do.

No amount of writing by economists will eliminate the hostility to individuals who make money when times are bad. Still, in designing policies to reduce the future severity of financial and other economic difficulties, it is important to continue to emphasize that speculation serves a useful social purpose.

To sum up: In order to achieve success you need to know what you want to accomplish. You should want to become a successful speculator in a variety of markets. There will always be a debate on the social usefulness of our activities as speculators but at least now you know how to face this debate.

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