Speculation

The Truth About 'Speculation'

Stock and futures market speculators get a bad rap. People have the idea that there is no value in people "gambling" on commodities prices, for example. This is due to a misunderstanding of the role of speculators. It is crucial to a modern economy. Let's use corn for an example of that role.

A farmer can plant corn, only to see the price drop so low by harvest time that he loses his investment. He prevents this by selling his future production now, at a set price. The contract that is created will go up and down with the price of corn, but the risk is all in the hands of the speculators who buy them. They profit if the price goes up, lose if it goes down. The farmer, though, has his price, and can plan his business now.

On the other side, a cereal company needs predictability in the prices of basic commodities, to plan future production. They don't want invest in new employees and equipment, only to see the price of corn triple, making consumers unwilling to buy their expensive corn flakes. So they buy a contract for future delivery at a set price. Now they can plan, and again, the speculators take on the risk. In this case, they make money if the price drops, and lose if it goes up, because they have to deliver at a set price.

Farmers and all industries based on basic commodities would go through terrible swings in fortune if it weren't for these "gamblers." They take on the risk, so the economic planning can be more practical. Without them, there would be more bankruptcies, and more dramatic swings in consumer prices. Speculators provide the liquidity needed in all markets.

Speculation Inventions

Perhaps we need more speculation, not less. For example, wouldn't it be nice to guarantee that gas for your car will be near the same price next year? Speculators could provide that guarantee, and some businesses would love that kind of predictability.

You buy a contract now, for example, to get your next 1000 gallons of gas at $2.20 per gallon. The speculators role is to back the other side of the contract (to sell it). If the average price for the next 1000 gallons is $1.80 for example, you still have to pay $2.20, so he makes $400 on the contract. On the other hand, if the price averages $3.30, he gambled and lost $1,100, because you still pay $2.20 for each of those 1000 gallons.

Imagine the many contracts that could be invented, based on speculation.

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