Is Speculation Bad for the Market?
Thank You Mr Speculator
I am often asked this question by people who do not understand the intricacies of the market. Whenever people lose money, they echo these sentiments. On 11 October 2018, Sensex fell by over 1,000 points, and the Economic Times reported that investors lost a wealth of ₹4 lakh crore in 5 minutes. The blood on the street belongs to the speculators and not the investors. And when they spilt blood, often you heard that speculation should be ‘banned’.
Such sentiments are often expressed in the commodities market too. When the oil prices rise, all fingers point at speculation, and people blame the government for creating infrastructure for speculators to indulge in excessive speculation.
It looks so obvious. If something is so bad, should the government not declare it illegal? Well, the simple answer is, speculation is not at all bad for the market. Speculation may make the speculator an overnight king or a pauper since he wins big and loses big, yet it performs important economic functions for the market. The presence of speculators helps, not hinders, the attainment of perfection in the market. Let us try to understand what at first sight looks like a paradox.
As discussed earlier, speculation is the practice of engaging in risky financial transactions to profit from short-term fluctuations in the market price of a security rather than attempting to profit from the underlying financial attributes embodied in instruments such as capital gains, dividends, or interest.
Speculators pay little attention to the fundamental value of a security and instead focus on price movements. In doing so, they perform a host of economic functions.
1. Price Stabilisation Function
While this applies to commodities and securities, it will be easier to understand it as it applies to commodities. The economist Nicholas Kaldor has long recognised the price-stabilising role of speculators, who even out ‘price fluctuations due to changes in the conditions of demand or supply’.
The speculator and hedge fund manager Victor Niederhoffer has beautifully explained it thus:
Let’s consider some principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.
The speculator is an opportunist. He makes hay while the sun shines. He makes money by filling the gap. Speculators, along with arbitrageurs and hedgers, keep exploiting the price gap. This leads to a more perfect market with more logical pricing. Contrary to what we believe, speculation helps price stabilisation in the long run. In the short run, speculation may cause hiccups in the market, but that is a part of the long-term stabilisation process.
2. Providing Liquidity to the Market
Another important service that a speculator provides to the market is, in risking his capital, he creates liquidity. Let us understand why this is so important.
We shall again use the example of a commodity since it is easier to understand. We consider a thinly traded commodity on NCDEX (which is the commodities market in India), say guar gum. Guar gum is an extract derived from guar seeds and is used as a natural thickener, emulsifier, stabiliser, bonding agent, etc. A chemical manufacturer who wants to buy guar gum goes to the market, but he may find no seller since the trades are not frequent. When a seller of guar gum wants to sell, there may not be enough buyers. In the former case, the buyer will have to pay a premium over the normal price since there is not as much quantity up for sale as the demand. In the latter case, the seller is likely to get a lower price. This price difference, known as the spread, occurs because there are not enough numbers of buyers and sellers at the same point in time. The speculator (an opportunist) will buy or sell any commodity where he finds the spread is large. He is risking his capital and filling the gap. Since a speculator often works with leveraged money, he can buy as much as ten times the actual buyer and can sell as much without owning a piece (thanks to the futures market).
With the market filled with a mix of investors (or actual users in the commodities market), hedgers, arbitrageurs, and speculators, you can imagine how much the volume will increase. It may be as high as 100 times the actual trade. (In the stock market and in the commodities market, you can find out how many of the deals are being settled for ‘delivery’ and how many are being ‘rolled over’.) The presence of numerous players leads to greater market efficiency. The greater quantity being traded lowers the spread, thus helping both buyers and sellers. It may sound ridiculous, but in tiny commodities like guar gum, the daily traded volume may sometimes be more than the annual production of the commodity!
3. Bearing Risks
A speculator loves risk; he earns his bread by taking risks. Sometimes he gets a cake to eat. Sometimes he sleeps on an empty stomach. He takes upon himself the risk that the seller or buyer of the commodity (or the investor in securities) would have been required to assume. A farmer can agree to sell his produce to a speculator in a forward market and can sleep knowing his produce has been pre-sold.
So much in praise of the hero of the market. And I am sure now you understand why you need speculators to help you succeed as an investor. Consider a hypothetical situation where every investor in the market is a clone of Warren Buffett. If everyone buys the mismatch between price and value, there will be no gap left soon, and once you reach the stage of equilibrium between value and price, there are no further profits to be made, except the profit arising out of the growth of the company. The equity market will have to be closed down since the uncertainty is gone. When all become Warren Buffett, Warren Buffett will be reduced to a purchaser of what looks like an equivalent of the government bond. Of course, this would never happen. Thank you, Mr Speculator.
(Dr. Tejinder Singh Rawal is the author of Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation)
Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation
I am often asked this question by people who do not understand the intricacies of the market. Whenever people lose money, they echo these sentiments. On 11 October 2018, Sensex fell by over 1,000 points, and the Economic Times reported that investors lost a wealth of ₹4 lakh crore in 5 minutes. The blood on the street belongs to the speculators and not the investors. And when they spilt blood, often you heard that speculation should be ‘banned’.
Such sentiments are often expressed in the commodities market too. When the oil prices rise, all fingers point at speculation, and people blame the government for creating infrastructure for speculators to indulge in excessive speculation.
It looks so obvious. If something is so bad, should the government not declare it illegal? Well, the simple answer is, speculation is not at all bad for the market. Speculation may make the speculator an overnight king or a pauper since he wins big and loses big, yet it performs important economic functions for the market. The presence of speculators helps, not hinders, the attainment of perfection in the market. Let us try to understand what at first sight looks like a paradox.
As discussed earlier, speculation is the practice of engaging in risky financial transactions to profit from short-term fluctuations in the market price of a security rather than attempting to profit from the underlying financial attributes embodied in instruments such as capital gains, dividends, or interest.
Speculators pay little attention to the fundamental value of a security and instead focus on price movements. In doing so, they perform a host of economic functions.
1. Price Stabilisation Function
While this applies to commodities and securities, it will be easier to understand it as it applies to commodities. The economist Nicholas Kaldor has long recognised the price-stabilising role of speculators, who even out ‘price fluctuations due to changes in the conditions of demand or supply’.
The speculator and hedge fund manager Victor Niederhoffer has beautifully explained it thus:
Let’s consider some principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.
The speculator is an opportunist. He makes hay while the sun shines. He makes money by filling the gap. Speculators, along with arbitrageurs and hedgers, keep exploiting the price gap. This leads to a more perfect market with more logical pricing. Contrary to what we believe, speculation helps price stabilisation in the long run. In the short run, speculation may cause hiccups in the market, but that is a part of the long-term stabilisation process.
2. Providing Liquidity to the Market
Another important service that a speculator provides to the market is, in risking his capital, he creates liquidity. Let us understand why this is so important.
We shall again use the example of a commodity since it is easier to understand. We consider a thinly traded commodity on NCDEX (which is the commodities market in India), say guar gum. Guar gum is an extract derived from guar seeds and is used as a natural thickener, emulsifier, stabiliser, bonding agent, etc. A chemical manufacturer who wants to buy guar gum goes to the market, but he may find no seller since the trades are not frequent. When a seller of guar gum wants to sell, there may not be enough buyers. In the former case, the buyer will have to pay a premium over the normal price since there is not as much quantity up for sale as the demand. In the latter case, the seller is likely to get a lower price. This price difference, known as the spread, occurs because there are not enough numbers of buyers and sellers at the same point in time. The speculator (an opportunist) will buy or sell any commodity where he finds the spread is large. He is risking his capital and filling the gap. Since a speculator often works with leveraged money, he can buy as much as ten times the actual buyer and can sell as much without owning a piece (thanks to the futures market).
With the market filled with a mix of investors (or actual users in the commodities market), hedgers, arbitrageurs, and speculators, you can imagine how much the volume will increase. It may be as high as 100 times the actual trade. (In the stock market and in the commodities market, you can find out how many of the deals are being settled for ‘delivery’ and how many are being ‘rolled over’.) The presence of numerous players leads to greater market efficiency. The greater quantity being traded lowers the spread, thus helping both buyers and sellers. It may sound ridiculous, but in tiny commodities like guar gum, the daily traded volume may sometimes be more than the annual production of the commodity!
3. Bearing Risks
A speculator loves risk; he earns his bread by taking risks. Sometimes he gets a cake to eat. Sometimes he sleeps on an empty stomach. He takes upon himself the risk that the seller or buyer of the commodity (or the investor in securities) would have been required to assume. A farmer can agree to sell his produce to a speculator in a forward market and can sleep knowing his produce has been pre-sold.
So much in praise of the hero of the market. And I am sure now you understand why you need speculators to help you succeed as an investor. Consider a hypothetical situation where every investor in the market is a clone of Warren Buffett. If everyone buys the mismatch between price and value, there will be no gap left soon, and once you reach the stage of equilibrium between value and price, there are no further profits to be made, except the profit arising out of the growth of the company. The equity market will have to be closed down since the uncertainty is gone. When all become Warren Buffett, Warren Buffett will be reduced to a purchaser of what looks like an equivalent of the government bond. Of course, this would never happen. Thank you, Mr Speculator.
(Dr. Tejinder Singh Rawal is the author of Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation)
Loads of Money: Guide to Intelligent Stock Market Investing: Common Sense Strategies for Wealth Creation
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