On your first point, I can’t agree with you. The stock market involves speculators; anyone who doesn’t believe that is unaware of the bubble in the tech market in 1999-2000. And there is no question that some people lost money; a whole lot of money. There is also no question that some people made (and kept) a whole lot of money, as they got out before the bubble burst.
In this case, we’re talking about the
futures market, not the stock market.
I fail to see, if people are speculating in the stock market and they drive prices up, that the same cannot be happening in the futures/options market.
Let me offer a brief, non-technical explanation of how commodity and futures markets work.
John and Jim have a problem. John is a wheat farmer. It costs him money to plant his crop, and he has no idea of what wheat will sell for at harvest time. He could lose a lot of money if the price is too low.
Jim on the other hand is a baker. He wants to expand his business. Of course, he needs wheat. If he borrows money to fund his expansion and the price of wheat goes up too high, he could go bankrupt.
Now imagine John and Jim get together even before John plants his crop. Jim has figured that if wheat doesn’t go above $40 a bushel (I’m picking this number out of the air), he can make a profit. John, the farmer, has figured that if wheat doesn’t go below $40 a bushel, he can make a profit.
So they sign a contract – even before the wheat is planted. John agrees to sell his wheat to Jim at $40 a bushel. And Jim agrees to buy it at that price.
The money is not paid over at that time (except for a token amount) – payment will come when the wheat is delivered.
How is this different from any other agreement to buy and sell? It isn’t – a thing (including a bushel of wheat) is worth what a willing buyer will offer and a willing buyer will accept. Of course the actual market value at harvest time may well be different. If it is higher that $40 a bushel, John will get less than if he had waited. And if it is lower, Jim will pay more than he would if he had waited. They both know that – and agree that setting an assured price is worth it.
The problem is, John is busy farming, Jim is busy baking. They haven’t got time to run around looking for buyers and sellers all the time. They need a market place where these “futures” are bought and sold.
Now come Mary and Jane. Mary says to herself, “I know in my heart that wheat will sell for $50 a bushel at harvest time. So if I can get someone to agree to sell me a million bushels at $40 a bushel right now, at harvest time I can borrow the money – using the signed agreement as collateral – and turn around and sell the wheat for a cool $10 million profit.” So Mary goes to the market, looking for someone who will sell her a futures option on a million bushels of wheat at $40.
Jane says to herself, “I know in my heart that wheat will sell for $30 a bushel at harvest time. So if I can get someone to buy a option on a million bushels from me at $40 a bushel right now, at harvest time I can borrow the money – using the signed agreement as collateral – and turn around and sell the wheat for a cool $10 million profit.”
So Mary buys an option from Jane, a million bushels at $40 a bushel. Since very little money changes hands now, whichever one of them is right stands to make a whopping profit. And whichever one of them is wrong stands to take a whopping loss. We call Mary and Jane “speculators.”
This is the characteristic of the commodities or futures market – it is a zero-sum game. For every profit, there is a corresponding loss – dollar for dollar.
Now, if this is true, how can speculators drive prices? They
can’t – if they could, it wouldn’t be a zero-sum market!! If the price of wheat goes down, Mary
cannot drive it up. If the price of wheat goes up, Jane
cannot drive it down.
Only supply and demand can influence the market – and speculators cannot control either of those factors.
