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Trading Lessons

Speculators getting rich at your expense

Politics / Social Issues Oct 21, 2010 - 07:55 AM GMT

By: Akhil_Khanna

Politics

Best Financial Markets Analysis ArticleSpeculators are individuals or organizations who place bets on outcomes of certain events likely to take place within a defined time period and earn huge profits on their occurrence. A simple speculation transaction would be to place bets on the results of a sports match. Team A and Team B are playing a football match. 10 people place a bet of $10,000 each that Team A will win and 20 people place a bet of $10,000 each on Team B winning the match. So we have bets of $1,00,000/- on Team A winning and $ 2,00,000/- on Team B winning. If Team A wins, the 10 people who won the bet would get $20,000/- each ($2,00,000 / 10) and the people who bet on Team B would loose all their money. Similarly if Team B wins, the 20 people who won the bet would get $5,000/- ($1,00,000 / 20) each and those who bet on Team A winning will loose all their money.


The odds of winning change as the amount of bets placed on each team changes. The maximum money is made when the least expected outcome occurs In the above example, Team B was the team most likely to win as most of the people had placed their bets on it. They had placed their bets based on the comparative strength of the teams and their performance track record. If Team B had won, every person who had bet $10,000/- on it would have earned $5,000/- (50% returns on money bet) whereas if Team A had won (the least expected outcome) every person who had bet on that outcome would have earned $20,000/- for every bet of $10,000/- (200% returns on money bet).

The field of speculation has evolved into a massive business in the last few decades due to the quantum of money involved in this field. Speculators have also got excess to a huge quantum of money (from the excessive money power of the rich population) and permission by law to trade on the various exchanges like stocks, commodities, bonds, currencies where they can continue doing what they do best. Some of the most common ways the speculators influence the prices of the outcomes of or prices of things they speculate in are :

1)        Influencing the outcome of an event

The speculators are no longer contented on chances of an outcome happening naturally on which they place their bets. They use their money power and influence to make an outcome happen in which they can make maximum gains for themselves at the cost of majority of the bet placing community. In the above example of the football match, the speculators would stand to make a maximum gain of $20,000/- if the team A won the match. In normal circumstances the outcome of the football match would be a result of the performance of the teams on the day of the match. The speculators want to make sure that they win the bet with maximum returns for themselves. So they now offer key players of Team B or the whole of Team B $10,000/- to play a poor game and loose the match deliberately in favor of Team A. The speculators would still make a confirmed profit of $10,000/- on a bet of $10,000/- even after paying off Team B.

They even used the newspapers, local radio network etc. to advertise the strengths of Team B while on the other hand highlighting the weaknesses of Team A leading the majority of betting people to believe how great the chances of Team B winning are match. This would encourage more and more speculators to place their bets on the outcome of Team B winning the match. This will lead to higher winnings for the speculators betting on Team A winning when Team B deliberately looses the football match.

2)        Circular Trading

A group of speculators can operate as a cartel and drive up the price of any investment option being traded using money power through circular trading. The objective of circular trading is to buy something at prevalent price and then boost its price artificially before selling it to someone else for huge gains. This would leave the purchaser holding an over priced asset worth much less than what they paid for. This puts profits in the pockets of the speculator and results in reduction of purchasing power of the genuine buyer / investor.

A, B, C decide to engage in circular trading in the shares of company XYZ which is currently quoting at a price of $ 10/- per share. They decide to distribute the profits obtained from this activity equally among them. A buys a big chunk of shares of the company at $10/- and sells it to B for $12/- who then turns around and sells the shares to C for $14/-.

Meanwhile other traders / investors see the share price increasing from $10/- to $14/- (40% increase) in a short period of time assume that some positive development is happening in the company XYZ which would lead to an increase it’s ability to earn future profits. They rush to buy the shares at $14/- each and due to the increased demand from the newly entered trade$ and investors, the share price of the company increases to $16/-. C then sells all his shares at an average price of $16/- to the people currently buying them. Once C has got rid of all his shares the price gradually starts dropping as there is no change in the operations or profitability of the company XYZ. The share price is soon back to $10/- which was the fair value price of the company and the price at which it was trading before the circular trading started. Hence a lot of people ended up buying the shares at $16/- now sit on losses on their investments.

Similar modus operandi is used in the commodities and the property markets. A commodity or property in an area is first bought by the speculators with deep pockets. The specific investment is then advertised as being the best possible way to make your money grow using either word to mouth publicity or the media. The promotion is relentlessly done till most of the investors are convinced that if the investment is not bought now, it would be a major opportunity lost. They gradually start buying the investment in anticipation that someone else will buy it from them for a higher price and create a self generated demand loop which boosts its price. As the price increases more and more people rush to buy it. You have to keep in mind that there is no fundamental change on the ground with reference to the investment option, only the attitude of the people towards it has changed because of distorted publicized information regarding it. This normally happens when investors stop valuing an investment option on the basis of its traditional valuation methods and rush to buy it only because it’s price is increasing for reasons which they don’t understand. The process goes on till the initial speculators sell all their holdings to the new investors and there are no further investors willing to pay the prevailing high price to buy it. The price then drops to the level from which it had started increasing or even below it as too many investors, who bought it last, try to sell it at the same time.

The same process in reverse is used by the speculators to drive down prices of good investments which they want to buy for themselves. Suppose there is some positive development regarding a company which the speculators have come to know of in advance. They begin spreading negative information or rumors about the company which would lead to genuine investors selling their holdings or less and less people interested in buying them. The price of the investment drops leading to more and more people selling their investments. The speculators on the other hand keep on gradually buying as the price drops and hence accumulate the investment at lower prices. As the selling by genuine investors subsides, the price gradually stops falling and the investment option ends up in the hands of the speculators at great valuations, the benefit of which they reap by holding on to it till its valuations rise to its real worth. Circular Trading leads to volatile movement in the price of stocks, commodities, properties etc. for reasons which have little or no relation to the fundamental factors governing the investment option.

3)        Hoarding

Another common method used by speculators to artificially increase prices is hoarding. Bill, a large dealer of maize decides to make extra ordinary profits for himself by hoarding maize. He has access to large sums of money either from his own earnings or his ability to borrow from lenders at the prevailing rate of interest. He starts buying maize from the farmers and the dealers at whatever price it is available. He buys a majority of the stock in the market and stores it in his various warehouses around the city. Gradually there starts being a shortage of maize and the buyers are willing to pay whatever price for it which Bill demands. As the price rises less and less people are able to afford maize for consumption but whatever quantity is being bought is traded at very high prices leading to massive profits for Bill.

Hoarding is a result of buying a major volume of the available quantities of stocks, commodity or property being traded by a select few people, creating artificial scarcity, who then turn around and sell it to genuine buyers at inflated prices. This results in major profits for the speculators at the expense of reducing the purchasing power of the genuine consumers / investors Rules are made in most countries to check hoarding of essential goods like agricultural products but things like hoarding of stocks traded on an exchange or property for abnormal profits is difficult to regulate.

A person who has major financial muscle can buy up all the apartments being built in a new block from the builder and then sell it at a premium to people who wish to buy it for residential purposes. The buyers who would want to purchase the apartment in that specific block would have no other option than to buy them from the speculator at prices demanded by him. It is similar to black marketing of cinema tickets but on a much larger scale. The risk to the speculator is that he should be able to find enough genuine buyers to buy his apartments at much higher prices than what he paid for them. If the buyers collectively decide that the apartments are not worth the price the hoarder is asking to sell them, he will be stuck with unsold apartments and then would have to sell them at whatever price the genuine buyer is willing to pay for them resulting in loss.

4)        Front Running

Front running is a method of artificially boosting prices of investment options based on quicker and faster information available to the speculator. John wants to buy a plot for construction of his house on Beverly Road in his city. He is only willing to buy the plot there as it is where his ailing parents stay and he wants to be near them to take care of them in their old age. There are a total of only 25 plots available on that road. Each plot commands a price of $ 10 million in the market today. He informs the property brokers about his intentions to buy any plot on sale and also expresses his intention of buying the plot only in that area. The brokers are aware of John’s ability to pay for the plot and his urgent need for the same. The brokers bought the only plot which came for sale in that area in the next three months for $10 million. As time passed John got desperate to find a plot for himself. The brokers then sold the plot which they purchased from the seller to John for $14 million. John too had no other option but to buy the plot at a huge premium from the brokers This lead to huge profits for the brokers and John ended up paying a 40% premium for the plot than it would have cost him under normal circumstances.

All the trading done worldwide nowadays is on electronic exchanges. Front running in is possible in all exchanges by anyone having large sums of money, super fast computers and relevant soft wares. The software in super fast computers are able to check the orders placed by people wanting to buy and sell stocks or commodities on the exchanges. They then buy from the people willing to sell and sell the same to the people willing to buy at marginal price difference of less than .01% per unit. This appear to be a very small amount but considering that millions of stocks and commodities are traded daily on the exchanges, the total amounts to huge profits on daily basis to the speculators engaged in front running. This type of trading is also termed as High Frequency Trading.

The effect of high frequency trading can be understood by how a broker executes Pam’s and Jane’s order to buy and sell shares. Pam’s instructs her stock broker in the morning to buy 1000 shares of ABC company up to a maximum price of $102/-. The shares are trade throughout the day in the price band of $100/- to $102/-. Another client of the broker, Jane wants to sell 1000 shares of the same company. She instructs the broker to sell the shares at not lower than $100/-The broker transfers the shares of Jane to Pam’s account. He tells Pam that he has bought the shares for $102/- and tells Jane that he has sold her shares for $100/. The broker pockets the difference of $2/- per share on the transaction apart from getting his commission from both Pam and Jane for buying and selling the shares. High Frequency Trading plays the role of such a broker executing millions of transactions per second making profits for the speculators.

Effects of the Speculation on World Economy

The price of a product is now derived by the manufacturer/producer reaching the consumer of the product after passing through hundreds of speculators resulting in a product costing the manufacturer/ producer say $20 per unit costing the consumer $80 per unit resulting in cost increase in price due to speculation by $70 per unit. This price discovery method does not add any productive value to the improvement of the life of general population and is beneficial only to the speculators.

The negative effects of the rampant speculation are borne by the consumers and businesses using these commodities. The financial institutions make a few hundred million dollars in profits in speculative trading whereas Trillions of dollars are spent by the users of the commodities to purchase them at artificial high prices.

  • Everyone $1 increase in price of oil results in worldwide consume$ shelling out more than $18/- million per day to maintain consumption (World Oil consumption was 18.7 million barrels / day in 2009). The speculation in oil markets causes prices to change sometimes $5 in a single day.
  • The fall in demand of goods due to the large price variations has resulted in lots of manufacturers finding it difficult to earn a livelihood. This is applicable to most of the traders of commodities for actual consumption. The costs of producing almost every product increases substantially due to the trading activities, the brunt of which is borne by the common man.
  • Speculation plays a major role in food inflation worldwide. Consumers finding their true purchasing power decreasing as they have to shell out more and more money to eat the same quantity resulting in a decreased standard of living. More and more people are being pushed under the poverty line and millions of people go hungry daily as a result of rapid increase in food prices due to rampant speculation even though there are ample stockpiles of food supplies available.
  • Manufacturers and actual users of raw materials like copper, steel etc face a lot of problems in fixing their costs due to the volatile nature of the commodities. This has resulted in the manufacturers increasing the prices of their finished products leading to a fall in demand for them hampering their profits. They have to spend more to hedge themselves against commodity and currency fluctuations further reducing their profits.
  • This also results in reduced tax collections for countries because the incremental taxes the speculators pay is much less than the resultant tax losses due to shrinking in the businesses in the main economy resulting in a strain in their fiscal positions. In developed countries the result of slow down in the economy results in increased unemployment increasing the costs of unemployment benefits.
  • The speculation activity also results in misallocation of resources. Students choose to study the fields of derivative and commodity trading lured by the prospects of earning huge remuneration thereby bypassing the fields of environment or science where they can positively contribute to the living standard of the world at large.
By Akhil Khanna

akhil.capricorn@gmail.com

I am an MBA Finance from the University of Sheffield, 1992 and have more than 15 years of experience in the field of Financial Management. I am a keen student of the Flow of Money around the World and enjoy studying the fields of Currencies, Stock markets, Commodity Markets and Bonds.

© 2009 Copyright Akhil Khanna - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors


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