Essential Speculation

Most hate it, but everyone needs it

Speculation tends to get a bad wrap. When the prices of commodities rise and make our daily lives more expensive in the process, speculators are easily blamed. When they fall, speculators get no credit.

By and large, societies love it when there’s a scapegoat, somebody one can point a finger at. The locusts ought to be responsible!

So far, so bad.

What people forget is that speculation, trading, and investing are really the same. When you trade, you speculate. When you invest, you speculate.

Investing might be a longer-term form of speculation, but it’s speculation nevertheless. Long-term “buy-and-hope” investors speculate that whatever asset they hold long will appreciate in value and be worth more in the future.

Easily forgotten is the fact that price speculation in markets serves an important and useful social function. Without speculation, prices wouldn’t necessarily find a fair level, transactions in the real economy wouldn’t necessarily take place, and goods might not be produced or processed in the first place, thereby impacting all of us.

Let’s start with a producer of base metals, e.g., the operator of a copper mine. This operator may want to hedge its production by selling futures contracts. Essentially, this allows the producer to lock-in a price for its future production, which allows for longer-term planning and financing, which in turn may result in lower production costs and therefore lower end-prices for society.

A wheat producer on the other hand may be reluctant to immediately sell its expected harvest forward as, unlike in the copper example, the final wheat output will be highly weather-dependent. The producer might buy futures contracts at the start of the season to hedge against a bad harvest, and possibly sell futures later when the weather-related risks have subsided to lock-in a sales price.

But as is typical for futures markets, the traders on the long and short side almost never match. There might be too many sellers and too few buyers, or the other way around.

Speculators close that gap. Speculative trading provides much needed liquidity and price discovery for real economic users. A wheat farmer is not expressly a speculator but relies on a speculative market to help manage the risk inherent in agriculture.

For example, the size (or volume) a producer is looking to hedge by selling futures may exceed the buying interest. Or there might a mismatch in timing, for instance when, at the time the producer is looking to sell, there aren’t enough natural buyers willing to take the other side. Or the price level at which the hedger would like to trade might not match that of the other side.

Hence, well functioning markets require the involvement of speculators, long and short, in futures, in stocks, in interest rates - essentially in everything.

Speculators assume the price risk which other market participants are unwilling to take on, or for which a market price cannot be found. Without the participation of speculators in markets, our world would be very different, and the prices we pay for goods and services more erratic.

In exchange for taking price risk, speculators expect to receive a risk premium. That’s only fair. Risk comes at a price, and that price ain’t zero.

There’s not one constant, pre-determined price for risk. The price of risk is dynamic, and free capital markets are efficient at determining what the appropriate risk premium should be.

When speculators believe the risk premium embedded in futures prices is too high (or otherwise attractive for their book of business), they will sell, and vice versa. This means they are willing to provide liquidity to the market at limit prices, which in turn means they contribute to an efficient price discovery process for the things we need in our daily lives.