Does trader contribute to the society

Taipan Daily: Do Traders Add Value to Society?
by Justice Litle, Editorial Director, Taipan Publishing Group

A few days ago, an interesting note showed up in the Taipan Daily mailbag. Via e-mail, reader James K. wonders aloud whether traders add value to society. He isn’t sure that
they do.

Here is an excerpt:

Dropping a ton of money into a company, running it up, and then pulling out your winnings can't be much benefit to society as a whole. It's not company ownership, or intending to own a company, it's company manipulation to make the few rich and have others less astute pay their bill…

The charge seems to be that investing is a legitimate activity, whereas trading is not. (After all, who would challenge the need to invest?)

Speaking as a trader, your editor is clearly biased. But, given that caveat, there are two ways of looking at this question. The first requires stepping back and contemplating what “adding value to society” really means. The second requires asking what service the act of trading provides (i.e. what do traders get paid for).

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Not About the Job

The first important point, from this trader’s point of view, is that it’s not about the job. That is to say, what you do to make a living is not the best reflection of your social worth (or your impact on society as a whole).

So a trader isn’t out to save the world – or even change it for the better – with his day-to-day actions. This is more or less true. But what about someone in middle management at a shampoo company? Does apple-scented conditioner really make a difference to the well-being of the human race?

Or what about the person who bakes chocolate chip cookies, sells aluminum siding, or manufactures those little buttons that sit on top of baseball caps? Do those humdrum activities really “make a difference” in the long run?

It’s actually a trick question. There are very few jobs that “make a difference” with dramatic and obvious flair. If you happen to be an ER doctor, a nurse who specializes in prenatal care, or a bush pilot who delivers food and medical supplies to disaster zones, then your “value add” is obvious (and has a certain Hollywood quality to it). But the vast majority of jobs – probably 99% of them – aren’t like that.

This is why, assuming you make your living legally, the better measure is what you do with your time and energy, not how you earn your daily bread. The man (or woman) who adds value to society is a good neighbor… a part of the community… a supporter of charitable causes, a loving parent and friend and so on.

Society is bettered by law-abiding citizens – and sometimes law-breaking citizens, when the law is in error – living out their lives in positive ways. Unless you are Tony Soprano, it’s not so much about the job.

What Service Do Traders Provide?

One can further ask, “what service do traders provide?”

We know that investors, at least in theory, provide capital on a long-term basis so that healthy businesses can grow. This process of capital allocation – again in theory at least – is driven by constant assessment and re-assessment of which companies deserve more capital and which do not.

But traders, as it has been pointed out, do not stick around long enough to make a difference to the ultimate fortunes of a business. So what is the service they provide? What do traders really get paid to do?

Your editor can think of at least five different “services” that traders provide. They are:

* Liquidity
* Price Discovery
* Risk Transfer
* Counterbalance
* Entertainment

Liquidity

The first thing that traders do is add liquidity to the markets. Liquidity is a measure of how easy it is to buy and sell something, possibly in large quantities.

A stock like Exxon Mobil (XOM:NYSE), which routinely sees 20 million shares a day change hands, is extremely liquid. Most “pink sheet” stocks, which might only trade a few hundred shares a day, are not.

If there were no traders, markets would be far less liquid. This is because traders buy and sell much more frequently than investors do. An investor, who may only want to buy or sell on infrequent occasions, enjoys the peace of mind of knowing that, when he wants to make a transaction, there will almost certainly be someone on the other side willing to provide him a fair price. All things being equal, the person on the other side will often be a trader.

Market makers and floor traders were the original liquidity providers. Their frequent activity, and their willingness to buy and sell over and over again as large outside orders came in, helped to literally “make the market.” These days, floor traders are a dying breed and market makers are being replaced by high-powered computers. But the liquidity providing function is still there.

Price Discovery

What is the proper price of crude oil at this very moment? How about lumber? Treasury bonds? Microsoft shares?

The answer is, nobody knows for certain what the proper price should be. There are millions of complex variables swirling around the market place, and those variables are shifting and changing moment by moment.

The only way to determine the proper price, then, is for active market participants to “vote” on their best estimation of that price, over and again, through their buying and selling decisions. (It’s not a democracy though – rather than “one man, one vote,” it is more like “one dollar, one vote.” The large player who buys a million shares has more clout than the thousands of smaller players buying 100 shares each. )

Traders participate in the price discovery process by “voting” – with their own capital – on what the proper price of something should be. To the degree that the trader is correct, he or she is paid in proportion to the number of votes cast (i.e. shares or contracts bought and sold).

The trader’s shorter time frame doesn’t matter. Whether the holding period is three weeks or three days, the only way for the trader to get paid, in the long run, is to be more right than wrong in terms of contribution to the price discovery process. If you help nudge a market that much closer to its “correct” price – a price that is always changing – then you get paid.

And this constant process of price discovery is valuable because it allows non-investors and non-traders to know the price at which it makes sense to transact. The trucking company can know that spot gasoline is X dollars per gallon at such and such a time, that price being determined by an open and competitive market (with the help of trader inputs).

Risk Transfer

Another very important service traders provide, particularly in the commodities markets, is that of risk transfer.

Say that you are a wheat farmer with a very large crop out in the field. Your entire livelihood depends on this crop. If something happens to the crop – blight, drought or what have you – your farming operation could be wiped out. How do you address this risk?

Or say that you are a cereal manufacturer with high exposure to fluctuating grain prices. If the price of wheat or corn rises too high, your input costs will be too high and your cereal operation will go bankrupt. Again, how do you solve this dilemma?

The answer to both questions is, you find a speculator who is willing to take the unwanted risk off your hands. This is why futures markets were invented – so that suppliers and end users of commodities, like farmers and cereal manufacturers, could get shed of their unwanted risk and “transfer” it to someone else.

This process is known as hedging. When a cereal manufacturer buys grain futures contracts, those contracts act as a “hedge” against the risk of grain prices rising. If the cereal manufacturer has to pay an extra 5 million dollars in the cash market for physical grain, but those costs were offset by a 5 million dollar gain on the futures contracts, then the risk has been “offset,” or hedged.

The trader, of course, is only willing to take on someone else’s risk if there is an opportunity to make a profit. And that is why speculators (traders) are willing to step in and take the other side of the farmers’ and cereal manufacturers’ positions. Their trading provides a service in the form of voluntary risk transfer.

Counterbalance

Another important service traders provide is counterbalance. One need only recall the many bubbles of the past two decades to observe that investors sometimes lose their minds.

The idea of the sober, rational investor who never lets emotions get out of hand is a complete fiction. Sometimes investors get euphoric and bid prices up to the sky. At other times investors become manically depressed and send prices crashing to the depths.

At times like these, contrarian traders are like chiropractors. When the market gets out of whack, they help “adjust it” back to more rational levels by going against the herd.

In order to provide this service, though, it is necessary to stand back from the investing crowd – to focus on exploiting temporary aberrations in the market, as opposed to ignoring fluctuations and always investing for the long haul.

Short sellers – who are almost always traders – can even help provide stability in a falling market. This is because short sellers routinely “cover,” or buy back, their short positions at various levels during a down move. If things are ugly, this may be the only buying coming into the market at that time.

Without short sellers (and traders in general) counterbalancing the herd-like activities of investors, markets would spend more time shooting straight up and then plummeting straight down.

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Entertainment

Last but not least, good traders are like the friendly locals in a poker room. They are there to play with those who choose to play. If a tourist (or other casual player) wants to come in and make a market wager, the locals are happy to oblige.

And who knows? The tourist may, in fact, walk away with some money. When this happens, the locals do not begrudge the tourist their winnings. They smile and look forward to playing again some other time. (At least the smart ones do.)

In other words, traders provide an entertainment service in the marketplace. For those who want to play – to compete with the hope of winning money – the trader says “I’m your huckleberry.”

And when an investor buys a share of some super hot growth stock with the hope of making a killing, this is just what the investor is doing – competing! The trader provides a service in taking the other side.

Of these five dynamics – liquidity, price discovery, risk transfer, counterbalance and entertainment – no single dynamic dominates. The mix will vary from trader to trader, depending on the style employed. But most, if not all of them, are active to some degree at all times.

So what do you think? Do traders provide a useful (or at least justifiable) service to the marketplace… or are we all just parasites? Inquiring trader minds want to know: justice@taipandaily.com.

Warm Regards,

JL