The Speculator’s Role in Volatility
Much debate centers on the speculator’s role in commodity valuation. On more than one occasion, commodity market regulators testified to Congress and participated in interrogation hearings regarding the speculator’s role in excessive market pricing. The popular view in Washington seems to be that most of the blame falls on traders. Ironically, the government’s own QE program arguably plays a bigger role in higher commodity prices than speculators ever could. Nonetheless, for those of us with the luxury of being within the industry and understanding the nature of the marketplace, it is nothing short of scary to see our elected leaders making such uninformed assumptions and, eventually, decisions about what are intended to be free markets. The truth is, there is plenty of blame to go around, but there probably isn’t a better alternative than capitalistic price discovery.
The commodity markets are built on speculation; without it, there would be no market. The futures markets were formed to facilitate the transfer of risk from producers and users to unrelated third parties hoping to profit from price changes; I cover this in detail in Chapter 1, “A Crash Course in Commodities.”
Some evidence seems to suggest that speculation causes artificially inflated prices, at least temporarily. After all, commodities boom when anxious investors pour money into the alternative asset class in search of higher returns. Additionally, what was once an investment arena utilized only by the uber-rich and risk-hungry investors now sees money inflows from average retail investors and even pension funds. However, the door swings both ways; during waves of liquidation, as investors redeem funds from their commodity holdings, the market sometimes behaves as if someone is pulling the floor out from underneath it. Consequently, prices often fall much further and faster than they might have without speculative excess. In such a scenario, the economy enjoys commodities at highly discounted prices. Naturally, you will never hear complaints that speculators are driving gas prices too low!
In my opinion, speculators don’t cause bubbles, or even pop them, but unfamiliar, inexperienced, or greedy speculators might share some of the blame for their magnitude. Without support from basic supply-and-demand fundamentals, a market cannot sustain pricing in the end. Thus, if and when speculation does move prices beyond what the equilibrium price might be, it eventually has to correct itself. The problem is that there is no telling how far and how long prices can remain distorted. Unfortunately, many traders are introduced to this the hard way.
It is critical to realize that, from a trading standpoint, it doesn’t necessarily matter whether the market is driven by fundamentals, technicals, speculators, hedgers, or the Fed’s QE efforts. What does matter is that prices move, and you want to be on the right side of it—or at least get out of its way. Markets are unforgiving; regardless of how strongly you feel that prices should behave in a particular way, they are sometimes driven by irrational speculation for much longer than you can financially and psychologically afford to be involved.
Excessive commodity market volatility and price excess creates unparalleled opportunities for futures, and options on futures, traders. With that in mind, it is imperative that traders approach the markets with the simple premise that anything is possible, and positions should be taken and risks managed with this in mind.