Thursday, February 7, 2013

What role do traders have in the market?

I got into a bit of a heated thread over at Babypips, regarding the role that traders play in the market.
There's a school of thought that traders and speculators serve no useful function since trading is a zero-sum activity and thus no wealth is actually being generated. This is somewhat misleading. If there are ONLY traders within a market, then yes, I believe it is a zero-sum activity and any wealth generation is arguable.
Of course, traders are not the only players in the market. We have corporations who participate in the market for operational reasons, whether it be to raise cash via an IPO, hedge their risk, or supply the market. We have mutual and retirement funds seeking long-term investments. We have debtors liquidating assets to balance their sheets. We have governments and central banks pulling fiscal and monetary levers to direct the economy.
Bearing this in mind, I believe the trader serves three useful functions in the market:
1) We increase liquidity. An illiquid market means higher transaction costs and longer times for orders to fill. By adding our liquidity, we decrease both and ensure a smoother, quicker and efficient market.
2) We provide risk management for risk-averse companies. It may be tedious, if not dangerous, for a company to see fluctuations in the price of raw materials or currencies. To hedge this risk, a company may lock in a futures contract, guaranteeing a stable price for the foreseeable future. Traders serve as a counter-party towards this hedge. Without traders, there may be no counter-parties, and thus no hedge, and companies will be disadvantaged.
3) We bring the market closer to equilibrium. Without our input, markets may be manipulated or distorted beyond reason. Our goal, as speculators, is to define what we consider "fair value" and bring the market towards this level. If we believe something is cheap, we buy. If it's too expensive, we short. We exit when price is at "fair value", having completed our duty in punishing any unwarranted hysteria or panic.

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