Speculators get a bad rap, especially when oil prices spike or a currency's value is shattered. This is because the media often confuses the line between speculation and manipulation. Manipulation leads to overall economic damage, whereas speculation performs several important functions that keep our economy healthy. In this article, we'll look at the function of speculators in the market.
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What is a Speculator?
Before we get too deep, we have to make a distinction between a speculator and your typical middleman. A middleman can be thought of as the means by which products are dispersed. It would be a very different world if the products we need and/or want were produced nearby. More often than not, every product in your house has at least a component that has taken an international voyage to get there. The markup of the middleman usually matches the materials and overhead costs used to ship, sort, bag and display those products in a store near you, plus some profit to keep the middleman fulfilling this function. This gets maple syrup to Hawaii, Korean laptops to New York and other products to destinations where a higher profit can be realized.
In contrast, the speculator makes his/her money through contracts that allow him/her to control commodities without ever directly handling them. Generally speaking, speculators don't arrange shipment and storage for the commodities that they control. This hands-off approach has given speculators the erroneous image of aloof financiers jumping into markets they care nothing about in order to make profits from the producers – the salt-of-the-earth types that legislators are always claiming to defend. (To learn more, see How Do Speculators Profit From Options?)
The most obvious function that people overlook when criticizing speculators is their ability to head off shortages. Shortages are dangerous because they lead to price spikes and/or rationing of resources. If a drought kills off half the yield of hay in a given year, it's natural to expect the price of hay to double in the fall. On wider economies of scale, however, these shortages are not as easy to spot. That's why commodities speculators help to keep an eye on overall production, recognizing shortages and moving product to places of need (and consequently higher profit) through intermediaries – the middlemen who use futures contracts to control their costs. In this sense, speculators act as financiers to allow the middleman to keep supply flowing around the world.
More than merely financing middlemen, speculators influence prices of commodities, currencies and other goods by using futures to encourage stockpiling against shortages. Just because we want cheap oil or mangoes doesn't mean we should blame speculators when prices rise. More often, other factors, such as OPEC and tropical hurricanes, have raised the risk of a more volatile price in the future, so speculators raise prices now to smooth down the potentially larger future price. A higher price dampens current demand, decreasing consumption and prompting more resources – more people to take up mango growing or more funds for oil exploration – to go into increasing stockpiles. This price smoothing means that, while you might not appreciate paying $5 for gas or a mango, you will always be able to find some.
While people may recognize speculators' importance in preventing shortages and smoothing prices, very few associate speculation with guarding against manipulation. In markets with healthy speculation, that is many different speculators participating, it is much harder to pull off a large-scale manipulation and much more costly to attempt it (and even costlier upon failing). Both Mr. Copper and Silver Thursday are examples of ongoing manipulations that eventually collapsed as more market speculators entered opposing trades. To avoid manipulation in markets we need more speculation, not less. (For more, read The Copper King: An Empire Built On Manipulation.)
In thinly traded markets, prices are necessarily more volatile, and the chances for manipulation are increased because a few speculators can have a much bigger impact. In markets with no speculators, the power to manipulate prices swings yearly between producers and middlemen/buyers according to the health of the crop or yield of a commodity. These mini-monopolies and monopsonies result in more volatility being passed on to consumers in the form of varying prices.
Consequences and Currency
Even when we leave the level of commodities and go into one of the largest markets in the world, forex, we can see how speculators are essential for preventing manipulation. Governments are some of the most blatant manipulators. Governments want more money to fund programs while also wanting a robust currency for international trade. These conflicting interests encourage governments to peg their currencies while inflating away true value to pay for domestic spending. It's currency speculators, through shorting and other means, that keep governments honest by speeding up the consequences of inflationary policies. (To learn more, check out Forces Behind Exchange Rates.)
Show Me the Money
Speculators can make a lot of money when they are right, and that can anger producers and consumers alike. But these outsized profits are balanced against the risks they protect those same consumers and producers from. For every speculator making millions on a single contract, there is at least an equal number losing millions on the trade - or a dollar on each of a million smaller trades. In very volatile markets, like those after a natural disaster or black swan event, speculators often lose money on the whole, keeping prices stable by making up the difference out of their deep pockets.
Hug a Speculator
Taken cumulatively, speculation helps us far more than it could ever hurt us by moving risk to those who can financially handle it. Despite the misunderstanding and negativity speculators have to face, the potential for outsized profits will continue to attract people, as long as governments don't regulate them into oblivion. With all the negativity aimed towards short-sellers and speculators, it's easy for us to forget that their activities maintain prices, prevent shortages and increase the amount of risk they undertake. I don't want to become a speculator, but it's important that we preserve speculative investing for the people who do – more than important, it's a necessity for a healthy market and vibrant economy. You don't have to become a speculator, or even hug the next one you see, just remember that the next time you pay $5 a gallon for gas, it's so we'll still have some left over for next week, year, decade and century. (For more, see Getting A Grip On The Cost Of Gas.)