A big question many people both in and outside the world of trading and financial markets love to ask and wonder about are whether traders and successful speculators add value to the world.
The people in the news media can claim that speculators do not add any value and are evil and corrupt people out to screw everybody for a chance to make a buck.
The people who work in the industry can think about the same thing. They may make a whole bunch of money and then feel guilty about it. There are even many speculators, both large and small, institutional and retail that have their incomes and trading profits capped because they feel that they are not adding value to the world and that extracted too much profit would be bad for society.
Traders Add Value
Traders do add value in their own way. No one is forced to execute transactions. No one has a gun to their head and is forced to buy a billion dollars worth of currency or a million shares of stock. Everyone is free to execute whatever transaction they want, and in many cases as big as they want. Everyone is free to execute whatever strategy or macro view that they want to in whatever financial instruments they see fit.
When the market trips some stops the downside, and you buy at the bottom pip of the move, you are surely adding value and liquidity. The person who sold to you was eager to sell. They wanted to sell really badly and you provided liquidity to them. They had an urge to sell at that specific price and you facilitated the transaction. They freely, of their own choosing wanted to sell and you helped them execute the order.
They could of sold for all sorts of reasons, some more rational than others. They could of been selling to express a bearish macro view. They could of been selling because their stop loss on their bullish view was reached. They could of been selling because their quant models told them to do so. They could of been selling because they saw an astrological pattern. They could of been selling because they thought they “knew something” that the market did not know. They could of been selling because of a chart pattern.
All sorts of reasons why traders take the actions they do.
Reasons For Placing A Trade
Whatever the reason was, you provided liquidity to them. Some people can say that they are on retail forex and thus their small orders don’t really add liquidity to the system since they are no on the real interbank. Even if your broker is your counterparty, they still want to hedge their exposure. So if you buy, your broker is selling to you, and they will want to buy in the interbank to hedge their net exposure.
Even if you are on retail forex, it still pays to think of the transaction as adding value and liquidity. Thinking like the big players and how they would respond to such orders is one of the components to fast success.
If you did not buy at the bottom tic, and there was no one else willing to buy, then there would of been potential for a stop cascade to happen. And if such a situation happened, then the person who wanted to sell would of gotten a much worse fill than they got.
So you bought at the price you did, and someone else sold at the same price. You obviously thought it was a good trade to buy, while the other person thought it was time to sell. You don’t know if your right. You believe you have the odds in your favor, but you can never be truly sure.
Paul Tudor Jones
In the Paul Tudor Jones Trader Documentary, Jones says:
When you take an initial position, you have no idea if you are right.
So you happened to buy, and it ended up being the bottom pip. Kudos to you and your analysis. On that particular trade you happened to be right, and the person on the other side of your transaction happened to be wrong. You made money, while they lost. Zero sum game. However, you provided liquidity to them, which is the value added. Had you not done so, they may have suffered an even worse loss. Or had you not done so, they may have missed out on a profitable trade opportunity if the market kept on falling.
Definition of Successful Traders
By definition, if you are a successful trader, you are generally a contrarian. And if you are a contrarian, you are providing liquidity when the market needs it the most. Providing liquidity when the market needs it the most is definitely adding value.
More trading and speculation generally helps the hedgers in the market as well. Volumes increase. Liquidity increases. Spreads decrease. Volatility can be dampened.
You can read one of my previous blog posts about what makes a currency pair liquid.
The proliferation of algorithms, macro traders, banks, hedge funds, retail traders, etc all engaging in forex trading is that the spreads get tighter. It is much easier profiting from a trade in the GBP/USD if spreads are 2 pips as opposed to 10 pips.
Back in the 1980’s spreads on currency pairs used to average 5-20 pips depending on the time of day.
Spreads have decreased, but volatility certainly has not decreased. Still plenty of inefficiencies to take advantage of. You could even argue there are even more inefficiencies to take advantage of in today’s environment.
Speculation Exacerbates Trends?
Some people may say that speculation exacerbates trends. There are times when it can exacerbate trends and volatility. Other times it dampens trends and volatility. For example when crude oil rose to $100 in 2008 you could have some good fundamental data to say that crude oil could be priced at $100. But then when crude oil rose to $150, you could say that speculation exacerbated the trend. That is a reasonable assumption.
However, the market was going to go wherever it wanted to go. And either it is going to go there in a liquid way with low spreads, or it is going to go there in an illiquid way with high spreads, low liquidity, and price gaps.
Also, just as the market can overshoot the topside, it can overshoot to the downside as well. When crude oil prices collapsed in late 2008, you could definitely make a similar case that speculation exacerbated the move. The fundamental value of crude oil may have been at $60, lets say, but the bearish speculators pushed prices all the way down to $35.
If a market is going to make a macro move or a fundamental move, it will make a macro move, whether or not there is “excessive speculation” or not. Having as many market participants as possible involved in the markets helps to increase the probabilities that the market movements are much more orderly, and with the best possible liquidity and lowest possible spreads.
Remember that you are providing value next time you catch the high or low of a move. You should not worry about the person on the other side of your trade. They performed their best analysis and made a decision of their own free will. The next trade may or may not be a win. Whatever the outcome, you should focus much more on capturing the next turning point as opposed to worrying over whether you are providing enough value to the world.
Successful traders do provide great value to the world. There aren’t many of them. Perhaps only 5% become successful. The ones who make it, tend to provide liquidity when the market needs it and is demanding it the most.
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