It’s Not a Game: In Defense of the Speculator1
By Christopher A. Bobin, Director, Bullion & Commodities Trading, United Overseas Bank Limited
The Speculator Condemned
Speculators and speculation have forever been demonized and many books and movies have dealt with this topic: From tulip bulbs in 17th century Holland to subprime mortgages in the United States at the beginning of the 21st century, the list is extensive and excludes no asset class or commodity, not even wine.2
But these extremes inevitably involve some element of nefarious activity like price rigging, supply cornering or outright fraud that have little to do with mundane speculation in organized exchanges. And yet, it is these extremes that color the public’s opinion of all speculators and put speculation in a negative light.
In sum, speculation is viewed as a type of subversive gambling: obsessive, addictive, excessive and ultimately financially ruinous to the people involved and peripherally damaging to others, particularly to those at the extremes of the economic supply chain. In commodities, it is the subsistence producer or the indigent urban consumer that receives the mantel of speculative victimhood.
Mere Mortals Ponder the Speculator
In any social situation the most dreaded question for me is “What do you do for a living?” If I’m honest, I pray for ignorance in order to get out from under the magnifying glass. Otherwise, I can expect closer scrutiny i.e. I am part of the cabal throttling the neck of the producer or the consumer.
Recently, I attended the opening of an art exhibition. The artist, a very earnest and talented young woman, blind-sided me with that horrible query. I decided to come clean given she was not “in the business”: “I trade commodities.” Silence. Suddenly she quipped “Oh, you mean like seafood? I have a friend who buys prawns and sells them to restaurants.” “Yes, something like that,” I replied.
Bottom line: the supplier of a physical commodity like prawns has a perfectly respectable role; however, contrast that with a speculator who has a bullish outlook on wheat, when the speculator has no intention of producing, consuming or storing wheat. That is sure to raise suspicions.
1 © 2019-2020 Christopher A. Bobin All Rights Reserved.
2 Sour Grapes (2016 film), Documentary by filmmakers Jerry Rothwell and Reuben Atlas on Netflix.
In the 1923 book Reminiscences of a Stock Operator, Jesse Livermore, recounts the time he showed his mother the money he made from speculation:
I was fifteen when I had my first thousand3 and laid the cash in front of my mother …my mother carried on something awful … She said it was more money than she ever heard any boy of fifteen had made, starting with nothing. She didn’t quite believe it was real money.4
Translation: “Son, please get a real job.” In fact, the accusation that speculation is not a “real job” has been frequently directed at me for over 35 years. So, these days, when I suspect an inquisitor is “in the know” I simply say, “Well, I invest my money and sometimes that of other people.”
For sure, “to invest” and “investments” have a principled air about them, and so the conversation veers into something prosaic like “What do you think the Fed’s going to do on interest rates?” For me, success in social situations involves dodging the proverbial bullet of defending speculation.
Hangers-On Need Not Apply
I define speculators here as full-time market operators whose bread and butter are speculation and reaping the joys and sorrows of said profession as an everyday occurrence. They go long, short, spread and arbitrage with substantial risk and do not “invest” except as it furthers their self-preservation.
I do not refer here to dabblers and other peripheral dealers at the operational end of the market, be they the ones crossing the bid-offer or those with the fastest execution algorithm. Don’t misunderstand, these have an important role to play. But bearing openended risk by envisioning future market outcomes is not one of them: That’s the purview of the speculator.
Trust me: the professional declaration of “I’m a broker/dealer/salesman/quant” will always receive the same social acceptance as the prawn supplier.
It’s Not a Game
The tendency to link market speculation with gambling is pervasive although fallacious. This is called the “Ludic Fallacy,” and was defined by Nassim Taleb in “The Black Swan.”5 It can be explained as follows: Only rule-based activities with uncertain outcomes are given to logical and quantifiable likelihoods. For example, casino games are rule-based and have probabilistic outcomes e.g. the odds of getting “snake eyes” from a fair die are 1/6.
No such odds can be attached to market predictions: There are no rules because the market –by definition– functions without them6 e.g. there is no predefined way markets discount new information. Thus, the whole rational of markets is that you’re not supposed to know because the price you see now is where a commodity clears, and where resources are allocated efficiently with all the information the market absorbed at that point.
Tomorrow, prices may be unchanged, higher, or lower but no ex-ante probabilities can be attached to those outcomes: We don’t know what new information tomorrow will bring or how the market may re-weigh the current information set. So, how can research reports attach a probability that the price of gold will rise above “x” or that of soybeans will fall to “y”? The answer is that such predictions are just educated guesses based on static analysis.
There is no crystal ball: The speculator is untethered and the next price wave either lifts him to new heights of wealth or leaves him unmoored and stranded with no wind in the sails and taking on water. Accordingly, if the first circle of hell for the speculator is social recrimination then the second circle of hell is financial ruin.
3 About USD 15,000 in 2020 dollars taking 2.8% inflation over 97 years compounded continuously.
4 Edwin Lefevre, Reminiscences of a Stock Market Operator (New Jersey: John Wiley and Sons, Inc. 2010), p. 6.
5 Nassim Nicholas Taleb, The Black Swan (New York: Random House, Inc., 2008), pp. 122-125.
6 Of course, organized markets have approved operational rules. Rules that dictate compliance and best practice are not what I am referring to here.
And Yet Life Goes On…
Within the cycle of life, most people don’t like unquantifiable risk and as such do not actively seek it. Quantifiable risks are welcomed: Entrepreneurship, invention, research, development, technology, and transactions of every sort function quite well within the accepted sociological framework of the corporate structure, national and transnational laws, contracts, venture capital, and labor-management arrangements.
Hence, some people sell their time as labor and some people leverage their time for entrepreneurial reward within the quantifiable and socially acceptable risk of the limited liability.
But what of unquantifiable market risk? How is it mitigated? We see that prices are erratic, one day shooting higher due to weather and the next day collapsing due to an unexpected political mandate. How do all the socially accepted forms of risk-taking function within the context of volatile and unpredictable markets?
Millions worth of commodities move from supply hubs to demand hubs over vast geographical and political boundaries every day: People are fed and clothed; factories are supplied; machines run, and transportation schedules are met within the context of volatile and unpredictable prices. How?
In Thomas Hieronymus’ seminal work Economics of Futures Trading for Commercial and Personal Profit, he writes:
Forward contracting quickly moved away from commercial interests into the hands of speculators. Relatively little was gained by passing risks from people who did not want them and could not carry them to people who didn’t want them or couldn’t afford them either. … Thus, early in the development, speculators became an essential part of the process. They were better able to assume the risks of price change than were the commercial interests.7
Professor Hieronymus then delivers the knock-out punch:
Speculators did not step nobly forward to assume their necessary place; they rushed in with enthusiasm and abandon to participate in an exciting game that held out the promise of huge profits. They cared not at all about their place in the economic world but were motivated by avarice and excitement. In large measure, they took the play away from the commercial trade. Speculation, then, is an activity in itself.8
Here we see the solution for unbounded risk: Enthusiasm, excitement and avarice of the speculator takes the other side of the unknown of what tomorrow may bring. The potential monetary bragging rights of “I was right, and they were wrong” but it all worked out in the end, is the be-all and end-all of the speculator: Life goes on.
7 Thomas A. Hieronymus, Economics of Futures Trading for Commercial and Personal Profit (New York: Commodity Research Bureau Inc., 1971), p. 93.
8 Ibid., p. 94.
How It All Goes Down
Commodities flow from origin to destination through many commercial hands: farmers, warehousemen, merchandisers and finally to an end user who utilizes it to make a product (bread, tires, clothes, chocolate, animal feed, etc.). Each commercial operator needs to lock in the value of the commodity –hedge—in order to dispense with price volatility and focus on moving the commodity along the supply-value chain.
The farmer may require a loan secured by a hedge on his future production. The warehousemen may see prices exceeding his cost of storage and so he rushes to hedge and lock in the “cost of carry.” The merchandiser may have customers who want to secure physical ownership now but prefer to price later, and so he hedges up until the customer decides to fix the price. And an end user may see better value and operational efficiency in futures versus cash and so he decides to pre-hedge.
Speculators take the other side of these commercial hedges, buying from the farmer, warehousemen, merchandiser and selling to the end user. As per Hieronymus, they do this not out of altruistic motive but rather to make money. The leverage embedded in the futures and options markets concurrently with the exchange clearing mechanism allows the transfer of large amounts of unpredictable price risk while mitigating the possibility of non-performance.
Once the price risk is out of the hands of the commercial trade, their efforts can focus on their business: getting a bigger or better tractor; blending the commodity up to grade; ensuring phytosanitary standards; securing logistics, extending or receiving credit, expanding or improving infrastructure or acquiring assets. With the logjam of price volatility out of the way, the supply and value chain flow smoothly. For our speculator, if he gets his directional view right then winner take all; otherwise, it’s on to the next trade –or worse– if he doesn’t.
And note that the speculator is cordoned off from the commercial trade in that he neither makes nor takes delivery of the physical commodity even though most exchanges allow for this. Why? Because, unlike the commercial trade, he doesn’t have the physical or informational infrastructure to move the physical commodity along the supply-value chain.
This last point is crucial in defending the speculator and redeeming him from his alleged malfeasance. In the words of Professor Craig Pirrong:
If speculators are truly determining price at the margin, they must be willing to pay the highest price –and, hence, must end up owning the commodity. That is, if they are determining the spot price, they must own the spot commodity.9
The converse is also true: if short, they must be willing to sell at the lowest price and end up delivering the actual commodity. In either case, they don’t, and they won’t, because they can’t. The jury has returned a verdict: “Not guilty.” Now only if the speculator could get his reputation back as well!
9 Craig Pirrong, Commodity Price Dynamics, a Structural Approach (New York: Cambridge University Press, 2012), p.101.
Disclaimer: The views and opinions expressed in this article belong solely to the author and not necessarily to the author’s employer.