Investment versus Speculation
An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.
Speculation is the process of selecting investments with higher risk in order to profit from an anticipated price movement. Speculation should not be considered purely a form of gambling, as speculators do make an informed decision before choosing to acquire the additional risks. Additionally, speculation cannot be categorized as a traditional investment because the acquired risk is higher than average. More sophisticated investors will also use a hedging strategy in combination with their speculative investment in order to limit potential losses.
Economic Benefits of Speculation
Ø Sustainable consumption level
Speculators play an important role in maintaining the balance between the supply and the demand by taking advantage of shortages and surpluses. 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.
Ø Market efficiency and liquidity
Another service provided by speculators to a market is that by risking their own capital in the hope of profit, they add liquidity to the market and make it easier for others to offset risk, including those who may be classified as hedgers and arbitrageurs.
In the absence of speculators there would be only producers and consumers in the market. With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell would be forced to accept an illiquid market and market prices that have a large bid-ask spread or might even find it difficult to find a co-party to buy or sell to. A speculator may exploit the difference in the spread and, in competition with other speculators, reduce the spread, thus creating a more efficient market.
Ø Bearing risks which in turn leads to production
Speculators also sometimes perform a very important risk bearing role that is beneficial to society. For example, a farmer might consider planting corn on some unused farmland by selling his crop in advance at a fixed price to a speculator. The farmer can hedge the price risk and is now willing to plant the corn.
Ø Finding environmental and other risks
Hedge funds that do fundamental analysis "are far more likely than other investors to try to identify a firm’s off-balance-sheet exposures", including "environmental or social liabilities present in a market or company but not explicitly accounted for in traditional numeric valuation or mainstream investor analysis", and hence make the prices better reflect the true quality of operation of the firms.
Shorting may top unsustainable practices earlier and thus reduce damages and forming market bubbles.
In all speculation is beneficial on two levels: First, without speculation, untested new companies (like Amazon.com, in earlier times, the Edison Electric Light Co.) would never be able to raise the necessary capital for expansion. The alluring, long-shot chance of a huge gain is the grease that lubricates the machinery of innovation. Secondly, risk is exchanged (but never eliminated) every time a stock is bought or sold. The buyer purchases the primary risk that this stock may go down. Meanwhile, the seller still retains a residual risk – the chance that the stock he sold may go up!
Why do Speculators Fail?
This can be explained with the help of the Speculator Emotional Cycle
The causes are rooted in basic human emotions that work against making the proper decisions to profit in a speculative market. The moment a speculative asset is purchased and the speculator has taken a position in the market, emotions are immediately in play. If the potential resale price in the market is rising, the natural reaction is to want more. Greed takes over and the asset is strongly coveted by the speculator. If possible, the speculator will go out and purchase more of the asset in question. This was common in the bubble when people would take the equity from one property and purchase even more residential real estate. The problem with this natural emotional reaction is that it prevents the speculator from selling the asset and taking profits when they are available. People who make a living participating in speculative markets have learned to override this natural instinct and sell when their emotions are telling them to buy more. The average residential real estate speculator does not have this discipline or awareness. They will hold the asset through the good times.
When prices begin to fall in a speculative market, most speculators immediately lapse into denial. They were so emotionally rewarded by purchasing and holding the asset, they see no reason to believe the first signs of a declining market are anything other than a temporary aberration. As prices continue to fall, the emotions change: fear begins to creep in, and the battle between denial and fear goes on well past the breakeven point where the speculator could have closed the position without losing any money. As prices fall further, the fear begins to take an emotional toll and the speculator starts to feel pain. The further prices drop, the more pain is inflicted on the speculator. What is the natural reaction to pain? Push it away. As a speculative investment becomes painful, the natural reaction is to want to get rid of it. This prompts the speculator to sell the asset – only after they have lost money. A speculator’s emotions always work against them. When the asset is rising in price they want more of it, and when it is falling in price they want less. This is a natural reaction, and it is the cause of all losses in speculative markets. This is why most speculators fail.
SPECULATION IN STOCK MARKET
Speculation is commonly used in the stock market. Many investors who tend to make money by speculating are known as speculators. This kind of action persists in the stock market due to different investors have different views about the same stock. Speculation can only exist if there is a variation in the price or the price is very volatile. Volume also plays a vital role in price creation. If there is a selling pressure the price tends to fall and vice versa in buying scenario. Speculation increases the consumption level in the stock market by pumping cash. The speculators bring liquidity in the market.
The major drawback with speculation is that it can emphasize sharp movements. Speculation causes deviation of price form their intrinsic value. Excessive of buying followed by selling pressures might lead to extreme downside of a particular stock.
- Buy on Greed, Sell on Fear
• Suppose you are a trader observing the bullish rally of Stock XYZ at the beginning of the 3rd bullish green candlestick, and considering an entry.
• You have witnessed the stock rally huge for two days and know that each trader who entered on the first two days is now a big winner.
• Based on the emotion of greed you decide to enter at that beginning of the 3 day, and mentally count your profits as the price rallies to a new high.
• After the stock closes, you brag to your friends at the golf course regarding the great trade that you made that day.
• You go home from the golf course and celebrate the victory with your spouse and maybe even discuss how you will use the extra money that you have earned through the trade.
• Now keep in mind that the profit is only on paper and not one penny has been earned yet.
• The next morning you check the price of your position, with expectations that your bullish stock will rocket to the moon! Now imagine the emotion that goes through your mind when your position not only fails to go higher, but also opens below your entry price.
• What is the emotion that flows through your body as you not only see your profits erode before your eyes, but now rob your account of precious capital?
• The emotion that you will experience is undoubtedly fear and will prompt you to scramble to liquidate your position as soon as possible to minimize your losses.
• Now consider that there were also 2 or 3 thousand additional traders who entered the same stock at around the same price with the hopes of the gaining the same
• All of these traders will be tripping over themselves trying to get out of the stock.
• As was illustrated in the previous section, this increase in fear results in an increase in supply of the stock relative to the increase in demand, and triggers the sharp decline in the price.
• The deeper the red candlestick cuts into the bullish green candlesticks, the more traders are thrown into loosing positions and thus the further the price decline.
• Perhaps you are beginning to realize the power of emotions in price movements of a stock.
• The technical analyst through candlestick reading is trained to read this greed and fear emotions in the market and capitalize on them.
This phenomenon works because of the greater fool theory (also called survivor investing) which is the belief held by one who makes a questionable investment, with the assumption that they will be able to sell it later to "a greater fool"; in other words, buying something not because you believe that it is worth the price, but rather because you believe that you will be able to sell it to someone else at an even higher price. It is similar in concept to the Keynesian beauty contest principle of stock investing. Some consider it a valid method of making money in the stock market, particularly momentum investors; however, fundamental investors believe that market participants eventually realize that the price level is too outrageous (too high or too low) and the speculative bubble pops. The greater fool theory relies on market optimism and market momentum concerning a particular stock, an industry, or the market as a whole.
SOME SPECTACULAR CRAZES
A Bubble exists when an asset’s price is driven by speculation – by the prospect of future price increases without regard for fundamentals.
In seventeenth century Holland, investors speculated wildly on tulips, putting up as little as 2.5% of their own cash. In 1637, at the height of the tulip mania, just one Semper Augustus bulb changed hands for 12 acres of land.
South Sea Bubble
In the South Sea Bubble of 1711, the English government needed to find a way to fund the huge debts it had incurred in the War of Spanish Succession. So the Lord Treasurer, Robert Harley, created the South Sea Trading company to help finance the government's debts. The company got exclusive trading rights in the South Atlantic plus a perpetual government annuity of over a half million pounds per year. In exchange, its investors agreed to assume responsibility for about £10 million of the government's debt.
It seemed like a win-win. But the government's sponsorship and the company's monopoly led to big trouble. The company's managers, thinking they had the government's largesse to fall back on, were complacent and ignored signs of economic troubles. They took excessive risk. And ultimately, investigations turned up massive fraud at the company and pervasive corruption in the government.
In 1720, investors drove up shares in the South Sea Company from 125 to 960 in six months and back down again to 180 in less than three months.
The "dot-com bubble" was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more recent Internet sector and related fields.
A combination of rapidly increasing stock prices, market confidence that the companies would turn future profits, individual speculation in stocks, and widely available venture capital created an environment in which many investors were willing to overlook traditional metrics such as P/E ratio in favour of confidence in technological advancements.
HOUSING BUBBLE - ONE OF THE BIGGEST SPECULATIVE MANIAS
Debt is the fuel of speculation. Without it, speculative bubbles cannot emerge. With it, prices can be inflated beyond the wildest imagination. By mid-year 2008, the Federal Reserve reported a grand total of $14.8 trillion in U.S. mortgages outstanding — 40% more than the entire national debt and triple the total of all the mortgages in America just a dozen years earlier.
It was not just the supersized of debt that was so dangerous but also the substandard quality of debt.
SPECULATION IN FOOD PRICES
Hunger revolt in Haiti! Bread rebellion in Cameroon! What had happened? The food prices increased drastically worldwide (see figure below). The FAO (Food & Agriculture Organization) food price index which covers the prices of the most important food commodities showed a price increase of 71% during the 15 months between the end of 2006 and March 2008. The increase was particularly dramatic for rice and cereals where the prices sky-rocketed to a peak of 126% in this time period. The head of the UN World Food Program Josette Sheeran called the rising cost of food ‘a silent tsunami.’
"Speculators create the bubble whereby, they increase prices with their expectations, with their bets on the future, and their activities distort prices, especially in the commodities sector. And that is just like secretly hoarding food during a hunger crisis in order to make profits from increasing prices." -George Soros
Given that other factors which influence food prices, such as increasing demand of emerging markets countries, stagnation in production or the use of agro fuels, rising oil costs, unpredictable weather and global stocks at 25-year lows are long term factors, they cannot explain that the FAO food price index increased by 71% during only 15 months between the end of 2006 and March 2008 and fell back after July 2008 within few months to the level of 2006. This hike can only be understood by looking at the mechanisms of food speculation.
HOW DOES FOOD SPECULATION WORK?
A significant portion of the increases in price and volatility of essential food commodities can only be explained by the emergence of the speculative bubble.
· The speculative move on commodity markets
- distorts prices
- reinforces instability
- increases market inefficiency
- periodically leads to the formation of bubble
- The worst effect: aggravation of hunger in developing countriesà has pushed millions of additional people into poverty.
Types of speculation with agricultural futures:
i. The Commercial Trade, the so-called “good speculation”
ii. The more harmful speculation by Institutional Investors such as Index and Hedge Funds.
GOOD SPECULATION or COMMERCIAL TRADING
The logic here is as follows: a farmer negotiates with a speculator in January that the speculator will buy the harvest at a fixed price in August. The arrangement is fixed by a contract. For the farmer, the advantage of futures lies in the security provided by the fixed price. He has transferred the risk to the speculator. The farmer must pay a fee for the derivative. The derivatives trader will also try to sell a corresponding future to the miller who buys the harvest in August to mill flour. The final price of the harvested grain is thus higher than it would have been if the farmer had sold directly to the miller, given the same conditions, because the derivatives trader's risk premium has influenced the price twice. The prices of futures lie slightly above those of direct trade (described as the cash or spot market), generally; however, the markets are stable if nothing unusual happens. The profits or losses achieved by the speculators are kept within limits. For all these reasons, commercial trading is often described as "good" or "useful" speculation. The CFTC (Commodity Futures Trading Commission) describes these traders as "hedgers", as opposed to "speculators“.
Here the traders are well-established experts in the market. They possess expertise and information systems with which they can provide relatively reliable forecasts on price trends. Commercial trade is quite closely linked to the fundamentals of these markets. In the 17th century, speculators bought the harvests of Japanese rice farmers even before they were harvested. The original motive was safeguarding, virtually an insurance (hedging).
HARMFUL SPECULATION & THE SPECULATIVE BUBBLE
This involves Institutional Investors investing in index funds and hedge funds.
Index funds: Such funds speculate on a basket of up to 20 or more commodities, primarily oil and metals (ores), but also agricultural commodities. Agricultural commodities usually account for 10% - 20 % of the index.
Index fund speculation is not in any way linked to the fundamentals of the food markets. They exclusively follow the trends of the stock exchange indices. And the strategies are based on these trends. Trade is largely automated, so that low transaction costs are incurred. Therefore, the investment or speculation behaviour of the funds is extremely pro-cyclic. Consequently, the contribution of the index funds to the food markets price bubble is not only restricted to the period from 2003 to 2007, but also contributed to the rapid increase in 2007. However, this can only be explained by another factor, the flight of hedge funds and other institutional investors from the crisis-ridden financial markets into the commodity markets.
A speculative bubble stared to emerge. Prices increased again uninfluenced by the fundamentals, because institutional investors were entering the market. The price increase in derivatives caused a rise also in the spot prices. On the one hand, buyers on the spot markets bought more ahead to put in stock for fear of further price increases. This increased demand and caused an upward pressure on prices. On the other hand, sellers delayed sales in anticipation of higher prices, and caused supply shortages. Speculation by hedge funds and others set in motion a whole chain of speculative behaviour by other participants.
OIL PRICE SPECULATION
The oil price is a strategic price since it influences the prices of all other products where oil is involved as fuel in production and distribution. This also applies to agricultural commodities. The production of these goods requires tractors and other machines which need petrol, and petrol is also needed to transport them to the consumer.
What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.
There are different views about speculation:
· Gamblers destabilize the marketsà Many see speculation as the reason for the capricious movement in the oil price. Gamblers speculate (ie, decide whether to buy or sell) seeing simple supply and demand in the market. The problem occurs because, as the volume of trade on the futures markets can be many times greater than actual production, the oil price today is purely speculative, and neither the producing countries nor the end users are able to influence it much. Gamblers at their terminals destabilize the markets and thus the whole world.
• Speculation influence future prices, not spot priceà If oil traders sell on the futures market, they normally do not purchase the oil until the agreed delivery date. They divert a portion of the production for their transaction and return precisely this amount to the market. In order to influence current market price, speculators must withdraw the oil prior to delivering it. For this, they need physical storage capacities. Only to the extent that they have these capacities can they influence the price.
Types of speculation with oil futures:
i. ‘Stabilizing speculation’ based on storage fluctuation
ii. ‘Destabilizing speculation’
STABILIZING SPECULATION based on storage fluctuation
Large oil companies have extensive storage that they can speculate with. The ships on the oceans are also gigantic storage tanks. Many fully laden oil tankers roam the seas and do not deliver their shipments because the owners of the oil maybe waiting for higher prices. This kind of speculation helps in stabilizing the prices.
• NORMAL CASE: It helps to smooth spikes in prices, since speculators only make a profit if they buy the oil cheaply and sell it at a higher price.
• LOW PRICE: They buy the oil and in so doing, increase the price.
• HIGH PRICE: They sell the oil, thus lowering the price.
OPEC is among the stabilizing speculators because it has a gigantic storage capacity in the form of oil reserves. Stabilizing speculation is what happened during the recent recession. Recession reduced the demand for oil. Before producers could adjust output, prices fell. But once the oil producing countries reduced their supply, prices picked up again in spring 2009. It is with regard to this stabilizing effect that it is often said, “OPEC should be regarded as an institution like a central bank that stabilizes the world economy.”
HOW IS OIL PRICE SPECULATION USEFUL?
At the moment it looks like we are starting to suffer real physical supply problems. Easily available oil reserves appear to have reached peak production and may indeed be starting to decline. So in this the speculators may be performing a useful role in raising the price. The events that happen in regard to this speculative activity are:
Available oil resources appear to have reached peak production à So production expected to start declining à Prices raised now as a result of speculation à Demand drops à Depletion rates slow down à Future prices do not rise as much as it would have otherwise.
Here speculators borrow cash or the object of speculation, to be able to exert a much greater leverage effect on the market. This is problematic for 2 reasons:
i. Speculators assume risks that they themselves cannot bear if their speculation goes awry.
ii. Individual speculators wield market power by themselves being able to influence the market price level.
The system gets completely destabilized if the traded quantities are so large that an individual speculator can change the prices. Others are cheated, and the market fails in producing economic efficiency and stability.
A currency speculator is somebody who buys foreign currency in order to sell it at higher price in the future.
I) Speculation is necessary to bring liquidity to international trade, foreign direct investments and financial markets.
Without currency speculation, international trade would be brimmed. In effect, an exporter, which bills their goods in foreign currency, need to pay its workers and suppliers in domestic currency. For instance, a German manufacturer exports cars to the United States. The US importer pays its bill in US dollars. Once the German exporter receives payment, it needs to change US dollars into Euros on the foreign stock exchange. Thus, it has to find someone who wants to buy those US dollars and to sell Euros. Currency speculators are simply middlemen in that process, charging transaction fees and hoping that they will make profit with fluctuations in the future. If a company wants to build a factory in another country, it needs also to exchange its domestic currency into foreign currency.
Consequently, there are two markets on foreign stock exchange: The primary exchange market which is linked to real transactions (exports, investments,) and the secondary market or speculative market which brings liquidity to the primary market. Currency speculation is necessary for importers, exporters, and investors, and that more speculation is generally better than less. The more currency speculators are involved in the secondary market, the easier it is for traders and investors to buy and sell foreign exchange when they need to.
II) An Excess of speculation brings instability and has to be regulated
We have to notice that markets are not efficient. Information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. That means currency speculation is like a guessing game where people try to know if the currency will appreciate or depreciate. Speculators gather information often on biased source to anticipate fluctuations. They also follow the other speculators, especially hedge funds that launch signal to the markets. Guessing game and herd behavior lead to self-fulfilling prophecies. A self-fulfilling prophecy is a prediction that directly or indirectly causes it to become true, by the very terms of the prophecy itself, due to the positive feedback between belief and behavior.
With those ingredients, currency speculators play a role in sparking or exacerbating economic crisis. First, currency speculation creates instability and disrupts international trade. It is riskier for an exporter to do its business, because he does not know the value of its exports in the future. Besides, hedging its transaction becomes more expensive with instability. Second, National governments and Central Banks are losing power. Currency traders are effectively policing governments by selling off a nation’s currency when they dissatisfied with that government's policies. In the case of euro speculation, financial markets discovered the weakness of European institutions and the laxity of Greek government to tackle its debt.
First, Greek debt attracted hedge funds and speculators which bet that the country will default. The price of Credit Default Swap (CDS) aimed at protecting creditors against a possible Greek bankruptcy went from a level of 120 in October 2009 to 420 on February 2010. People who buy CDS at such a high price are betting on the country bankruptcy, which will convert this high price in huge profit. That is the first self-fulfilling ingredient: the higher the bets, the more difficult it is for the country to refinance itself, and the higher the possibility of bankruptcy.
Standard & Poor and Moody’s decreased the ratings of Greek bonds that amplified speculation. Speculators don’t want to keep bonds rated BB+ in their portfolio. Thus, they try to sell their Greek bonds but they become junk bonds. They so they have to sell their other risky bonds, i.e. debt bonds from Spain, Ireland and Portugal, the most fragile countries in the Euro zone. Crisis becomes higher.
Hedge funds begin to bet on an implosion of the Euro currency area. Euro currency area is composed with different countries. First, there is a big gap between German economy and Greek economy. The value of a currency always reflects health of an economy. How the German could have the same currency as the Greek? Second, the European Union lacks a federal authority able to demand higher fiscal responsibility, higher transparency and better governance in sovereign debts management. Without federal authority, European governments and their ministers of finance had to implement a rescue refunding plan for Greece, but it took several weeks that let time to speculators to sell euro against dollars.
With all of these ingredients, Euro decreased against dollar. In June 2010, euro has lost 20 % of its January 2010 value.
• Speculators think that European Central Bank will tolerate higher inflation and rising inflation will cause the euro to depreciate further against other currencies. They anticipate by selling euros.
• Bad perspectives for economic recovery in Europe.
• Flight to quality. Speculators prefer to have dollars than euros.
The example of Europe proves that currency speculation brings instability because it often creates vicious spiral that could bring down an economy.
III) Institutional approach: Money is a public good so speculation has to be regulated.
Regulation theory (Michel Aglietta): “In the social-link model, money is the collective pivotal point in the relationship between the individual and society. A relationship between two individuals may be termed ‘commercial’ because it is conducted through the institution of money.”
Whatever it’s historical shape (fishes, seeds, goods, coins, notes…) money replaces violence between individuals. If a currency has no value, exchange between individuals and countries are impossible. And exchange and trade are a substitution to violence.
That theory has already been proved by facts:
· German Hyper inflation in the twenties which had helped Nazis to take power.
· In the 80’s hyper inflation of peso in Argentina which had led to riots in the streets.
· Violence and riots in Greece towards government measures.
If Money is a public good or an institution, currency speculation has to be regulated in order to avoid social crisis.