If you believe the mainstream media and the politicians they quote, the bulk of financial crisis are caused by “speculators”.  Speculation has come to mean, by some sort of press fiat, “trading we don’t like”.  This is unfortunate, because speculation has an older and more meaningful definition distinct from any implication of financial crisis.  This older idea is important because it describes what profitable traders do and how they make their money.  If you want to make substantial profits through trading, you will be speculating and thus you probably ought to know something about the subject.

Speculation: the act of buying something one does not otherwise want with the intent to sell it later at a higher price.  Alternately, selling something one does not wish to be rid of with the intent of buying it back at a lower price.

Now, depending on your mindset that might sound somewhat nefarious.  You’re taking people’s money after all – buying something cheap and selling it expensive.  But I contend there is nothing wrong with speculation in general.  For example, speculation is precisely what most retail stores do.  When the grocery store buys a pallet of canned green beans, it’s not because the owner of the store really wants all those beans.  He probably doesn’t even want one can of beans.  What he’s doing is placing a bet that a bunch of other people are going to come along and offer him more than he paid for the beans.  If he’s right, he makes money.  If he’s wrong, the beans go on “manger’s special” and get sold at a deep discount and he loses money.  He’s a speculator.

As you can see from the grocery store example, speculation serves as a sort of buffer between supply and demand.  In the simplified view of ECON-101, supply must always meet demand in the market – the number of cans of beans produced must equal the number of cans purchased and ultimately eaten.  Similarly, the price paid by the consumer must equal the price earned by the producer.  But it should be obvious that the real world doesn’t work that way.

• canned beans are produced one time of year (bean harvest) but consumed all year long.  Thus demand only equals supply when viewed over a long period of time.  On the shorter timeframe where the grocery store opperates there’s a mismatch.
• the bean producer wants to transact business in huge quantities – cases or pallets of beans.  The consumer wants a couple of cans at a time.
• The bean producer is willing to accept a much lower price per can than the consumer is willing to pay.

The first two bullets are economic problems in need of a solution.  The third is the economic incentive to find the solution.  Enter the speculator, or more specifically a market maker.  A market maker is simply a speculator who is willing to both buy and sell something if the price is right, and that’s exactly what the grocery store owner does – he buys beans cheap and in bulk, trusting that customers will come along and he can sell them expensively in small quantities.  The market maker’s key tool is his willingness to keep an inventory and dole out the beans as customers appear.  For this, he gets to pocket the price difference between producer and consumer.  The inventory requires capital, and the price difference is the return on that capital.

Obviously the purpose of this blog is not to delve into the details of running a grocery store.  But I want to convince you that speculation is not wrong or evil or bad.  Done correctly, it’s a rational bet taken by a businessman in order to make money and it solves economic problems for the other people involved in the transaction.  This is important to understand because it’s all to easy to be brainwashed by the media into thinking there’s something wrong with making money as a speculator.  If you get fooled into believing that, and have any sense of empathy, then you can never be a successful speculator because you’ll always believe you’re hurting the people you do business with and that will lead to self-sabotage.  Of course, that’s hogwash.  Yes, there are types of unethical speculation (which I’ll go into in some future post) which hurt the people you do business with.  But in general speculation is simply the process of giving people what they want – matching supply up to demand in an imperfect world.

Back in the realm of finance, there’s not much difference at this level between stocks or bonds and a can of beans.  For sake of example, let’s consider 10-year treasury notes issued by the US government.  They are issued in large blocks (typically 100s of $100,000 bonds) by the US treasury and sold at auction.  Various entities participate in the auctions, but the the purposes of this discussion just think about the treasury bond desk at a major investment bank (a so called primary dealer in T-bonds).  The desk buys these large blocks of bonds, split them up into the individual $100,000 bonds and sell them to other parties interested in investing in US government debt.  They buyers are pensions funds, investment funds, banks, and even individual investors.  The primary dealer solves the same economic problems for investors that the grocery store solves for shoppers.  The t-bonds are only produced when there is an auction (which can be irregular in timing, terms and quantity).  But the final customers for the bonds want specific quantities, and want them at specific times that may not correspond to auctions.  Hence, the primary dealers tie up their capital to maintain an inventory, but in return get to charge a premium for the bonds – typically a small fraction over what the bond cost at auction.

Note that, much like the grocery store owner, the primary dealer’s speculation includes an element of risk.  If the price of bonds declines while the primary dealer holds them in inventory, the desk looses money.  This is in essence equivalent to the case where no buyers show up at the grocery store wanting beans and they end up being sold as a manager’s special at a loss.

The bond case illustrates a fundamental distinction: the difference between speculation and investment.  The primary dealer wants the bonds because he predicts a buyer will appear at a higher price.  That’s speculation.  The pension fund where the bonds eventually land wants the bonds because of the payments they entail – coupon and principal payments.  That’s investment.

Investment – buying a security for the payments (technical term: disbursements) that you believe will come from it.

In other words the speculator is interested in the future  behavior of others trading the same security.  The investor is interested in the behavior of the security itself.  If the bond market shut down tomorrow, the primary dealer would be stuck with an unwanted inventory whereas the pension fund would simply be unable to buy more bonds, but would be perfectly happy to keep the ones already purchased.

This raises an interesting point: much of what is called “investment” in private brokerage accounts and 401K plans and the like is not actually investment – it’s speculation.  When someone buys Apple (AAPL) stock, they’re not doing it for the disbursements – there are none (Apple pays no dividend and is unlikely to be bought out).  Rather it’s because they believe that someone will come along and offer them a higher price for AAPL stock at some future time.  In other words, it’s pure speculation.  So for those wondering if speculation is in some sense “OK” to do, you can take comfort in the fact that the retirement accounts of most Americans are packed full of speculative bets.  Whether those bets are a good idea from the would-be retiree’s perspective is a different question – frequently they’re not.  Joe Sixpack is not generally a particularly capable speculator, and industry data suggests that most such accounts do poorly.  But he is a speculator.

The take-home point here is that most profitable trading is speculation.  I tagged this blog Education for Thinking Traders, but really it’s education for thinking speculators.  Investing in Coca Cola shares and making 2.6% yield per year is all well and good, but it’s not going to generate outsized returns or make anyone wealthy.  Speculation in contrast can, if done right, make a lot of money.  For example, the primary T-bond dealers described above typically return about 20% per year on capital.  That’s a lot better than the Coca Cola shares, or for that matter the bonds they’re dealing.  So if you want to make big money trading, you’ll have to engage in the old school definition of speculation.  And if you want to do it in such a way that you make money rather than lose it, you’re going to have to learn a lot about how to speculate effectively.  That’s what this blog is about.

Say it with me now: I’m a speculator, and that’s OK.