It happens every time the market crashes.
Sip some joe at the rural coffee shop and you hear all the usual complaints. The typical one goes, “This wouldn’t happen if we could get the speculators out of the market.”
Funny. You never hear complaints about the speculators when the market is going up.
It takes all kinds. Understanding the movements of the markets is impossible without understanding the roles of the players. Certain classes of people are involved in commodity futures trading, and each class has a purpose. If you want high prices, you have to learn to love the speculator.
Commodity futures have evolved over time from actual cash contracts delivered in such places as Chicago, to electronic, nearly instant, trading contracts based on cash contracts. In current form a commodity contract is still an actual cash contract, with an actual delivery date and time.
Most contracts do not ever actually involve delivery, but are “offset” by another contract. That is, one may sell a contract of 5000 bushels of July corn, and later buy it back, leaving no net obligation.
This means anyone can buy and sell grain, without actually owning any.
Since a contract does not need to involve actual grain, several classes of people trade commodity contracts for different reasons.
Hedgers and speculators
There are two large classes of traders, the hedger and the speculator.
“Hedgers” use futures contracts to lay off price risk to the futures markets. Hedgers may be buying or selling to “short hedge” grain.
The big hedgers are elevator operators who buy cash grain, then sell futures to hedge the price risk. If prices go down, the cash grain is worth less, but the futures are worth more. If prices go up, the futures are worth less and the cash is worth more. If you represent a big feed mill or feedlot or are feeding animals, the hedge is a “long” hedge.
At any time of the year you can buy grain on the futures market to protect yourself against higher cost if the price goes up on cash grain.
Then, there is the speculator. He is not trying to hedge his risk, or lay off the risk to the futures market. He is taking on risk, hoping to bet on price direction to make money.
We need them
At first glance, it could seem that he has no part in “our” market. In fact, he is what makes the market work.
First, the speculator provides liquidity. Because of the large volume of trading done by speculators, there are many times more contracts traded than there is actual grain. The benefit of this is that, at any given time, there is a market being traded.
If you want to sell futures, a trade is made almost instantaneously. There is, for all practical matters, always a speculator willing to take your trade.
Imagine a drought market where the users don’t want to buy grain because they see it as too high, and the producers don’t want to sell it because they think it will go higher.
The volume of trading here is not done by hedgers. But, there are always speculators willing to bet that the top is in, or ready to lift long spec positions to take profit out of trading.
They have no time investment in trading. They are not looking forward to a time when real grain will replace paper. They are looking only at numbers.
Trigger volatility
Second, the speculators provide volatility. The more speculation, the more market move is seen. A government report that is seen as bullish can only actually run the market up if the specs step in to buy it, sometimes in an irrational fashion.
We see large moves for short periods of time that provide opportunities for the producer to hedge on the futures or sell cash grain. Frequently, the moves seem all out of proportion to the news that caused them. Without speculators, there is not enough hype to make the big moves.
The speculators may be position traders or day traders. The position traders are looking to take a position and ride it until it looks like the move has matured. The day trader is not willing to take the risk of overnight changes, and evens up every afternoon. The electronic trading that goes on at night has lessened a lot of the risk of carrying positions.
Fickle friends
The downside of speculators is that they are fickle. They will set a price to take a profit and liquidate. If there are a lot of them following some trading company’s advice, the market can be adversely affected in a short time. They may even reverse positions, putting huge pressure on the market.
The producer needs to remember that volatility is good until the up move starts down again. Volatility works to your advantage if your timing and discipline are right.
The locals are traders who are only trying to scalp the market a fraction of a cent, trading huge numbers of contracts with small gains. They are the ones who actually act as order fillers for the trading brokers. Every order is actually filled by someone trading for his own account. They also provide instant liquidity for a trading order.
The local, by definition, wants no position for any length of time. I have always remembered being at a meeting in Chicago where a farmer asked a local his opinion on the market. The local was adamant: “I don’t know anything about the market. I just buy a quarter and sell a half.”
Farmers may be hedgers or speculators. They may sell futures or buy options to give themselves price protection. They may speculate on futures just like anyone else. If they do nothing, they are the biggest speculators of all.
Forty-some years in this business has convinced me that farmers have no business trading futures, but only options, and only as hedges. They need to understand how futures work to understand what services the elevator is providing for them. They need to sell grain as high as practical to the elevator.
The elevator hopes to sell futures to hedge them as high as possible. Then, as prices come down, money comes back to the elevator from some dentist/speculator. When prices are low, the elevator sells at good basis to the end user, and everybody but the dentist is happy.
I’m not losing too much sleep about him.
