# What's the benefit to society of stock speculation? \[edited title\] **URL:** \ **Category:** Great Debates\ **Created:** [November 4, 2011, 4:06pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864 "2011-11-04T16:06:06Z")\ **Posts on this page:** 20\ **Page:** 7
**Author:** ![MaxTheVool](https://avatars.discourse-cdn.com/v4/letter/m/9fc29f/32.png) [@MaxTheVool](https://boards.straightdope.com/u/MaxTheVool)\ **Post date:** [November 7, 2011, 5:13pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/121 "2011-11-07T17:13:01Z")
> [@DragonAsh](#): > > **MaxTheVool** , so you acknowledge that the stock market is a benefit to society…yet you can’t take it to the logical conclusion that if it wasn’t for people like Joe Smith, investing in the market and yes, sometimes making money, that the market wouldn’t exist to begin with? I’m not disagreeing with that, I’m simply trying to point out what I think was the original motivation behind asking the question in the first place. Certainly I’m not proposing that we outlaw or ostracize people who make money on the stock market. (I think another point worth addressing here in the more general discussion is that people trying to make money on the stock market are associated, in many people’s minds, with a wide variety of other people in the financial sector, some of whose ethical underpinnings are an awful lot more questionable… various people involved in setting up the conditions for the recent financial meltdown, for instance.) ---
**Author:** ![DragonAsh](https://avatars.discourse-cdn.com/v4/letter/d/db5fbb/32.png) [@DragonAsh](https://boards.straightdope.com/u/DragonAsh)\ **Post date:** [November 7, 2011, 5:40pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/122 "2011-11-07T17:40:31Z")
EDIT: Sorry this ended up so long. And I’m not even sure if I properly answered the question, but anyway… > [@yelimS](#): > > Thanks **MaxTheVool** for an excellent reformulation of my question, and **DragonAsh** for an excellent answer. A few things, though: > > You don’t address **septimus** ’ point about enough liquidity - is it true that the primary market only benefits from a certain amount of liquidity? Well, there are other things, of course, but in a nutshell, yes: The primary market would probably not exist if there wasn’t a liquid secondary market. And it starts even before that. Many companies would never get off the ground it if wasn’t for angel/venture capital/private equity financing. Venture capital funds, for example, are willing to take a complete loss on 90% of their investments, because they expect/hope to recoup all that and more from the successful 10%. In those cases, the common exit strategy is usually an IPO - think Google, which started out with a $100,000 investment - or being acquired by another company - think Skype and eBay. And all of that depends on an active, liquid secondary market, for the reasons noted above. > [@yelimS](#): > > \>Could there be put restrictions on how many are allowed into the secondary > \>market, to ensure that everyone who’s part of it, actually serves a function? You’ve gotten this turned around - everyone that participates in the secondary market is helping the market serve the function! By restricting access, you cripple the very function we want the market to serve. I guess I just don’t quite understand what you’re actually objecting to? Who do you think isn’t ‘justified’ in earning money from the stock market? > [@yelimS](#): > > \> what about day trading and computer generated trades - should they be limited? Re day traders - what possible reason would you suggest for limiting this? I assume you wouldn’t be in \*favor \*of only allowing companies such as banks to buy and sell stocks. Do you mean you’d require absolute holding periods, no possibility of selling the stock until a certain period of time has elapsed? What benefit do you expect from this? You do realize it would result, ultimately, in lower liquidity, which is Bad, for the reasons we saw above? Computer-generated trading (algorithmic trading, or just called ‘algos’) is nothing new - been around for decades; I’d bet that stock trading programs were one of the first uses of computing power, and the major investment banks have invested tens of millions of dollars into various trading systems and platforms, most of which eventually trickles down to retail investors (think trading platforms from E\*Trade, for example). Computer trading is most definitely A Good Thing, overall: More liquidity is better than less liquidity, as we saw above, there is a broad consensus that algos help lower trading costs, help narrow spreads, and generally result in improved pricing stability. The companies that build/develop/sell these algo systems certainly don’t have The Public Good in mind - they’re hoping to make a profit. But as is so often the case, once again the invisible hand comes to play. Note that algos and other program trading etc can present problems, but - as is usually the case, it’s a problem with the implementation, not the idea. For example, the flash crash of 2010: I wrote a blog post on this, so let me copy-and-paste from myself: The crash started from a large-ish computer trade sell order in E-Minis (index futures contract - notational value is $50 x value of the S&P500 index) that ultimately pulled the price down by about 3% in three minutes, from 2:41pm to 2.44pm. While a reasonably sharp sell-off, it’s not unheard-off. But in this particular case a handful of high-frequency traders jumped on the large order, and essentially started passing the position back and forth amongst each other (what the SEC report colorfully called ‘the hot potato effect’). Between 2:45:13 and 2:45:27 - just 14 seconds! - the HFTs passed around 27,000 contracts, but only added 200 net additional contracts. By this time, some automated trading systems started scaling back or pulling out of the market altogether, and this further drop in liquidity only exacerbated the declines. By 2:45:27, E-Minis were now down over 5%, and the SPY (an S&P500 exchange-traded fund) was down by about the same amount, caught up in the same liquidity drought. At 2:45:28, the Chicago Mercantile Exchange’s ‘circuit breaker’ kicked in, which didn’t halt trading, but did limit downward price limits…for five whole seconds. When trading resumed at 2:45:33, prices stabilized, the E-Minis and SPYs started to recover, and ultimately almost the entire decline was made up just moments after the crash had begun. During the crash - which, remember, only lasted about four minutes - stocks such as Procter & Gamble and Accenture were quoted at prices as low as $0.01, or as high as $100,000. We can only assume some traders made a small fortunate picking up stocks worth $40-50 for a penny. Why the crazy quoted prices? Because of so-called ‘stub quotes’. Unlike the Nikkei or the Paris stock exchange, the US stock market is an auction-based system (vs an order based system). That means that market makers must, at all times, offer to buy or sell the stock they make a market in. In return for being able to maintain a spread on every transaction for that stock, the market maker _must_ maintain a continuous two-sided quote. What happens is that some market makers have their trading platforms set up with ‘dummy’ quotes of a penny or $100,000. The idea is that they put the buy or sell price so far away from the current market price that there was never any actual intention or expectation that a trade would be executed at that price. But during the flash crash, all liquidity was soaked up, which meant that these stub quotes were acually displayed, and sometimes executed: > [@](#): > > ``` > "...some firms reported that their algorithmic trading systems attempted to execute against declining prices all the way down to stub quotes – either because such trading was consistent with the parameters for that system, or because the system did not necessarily recognize that it was hitting stub quotes..." > > ``` So yes, it might be bad news that computers trading positions back and forth to each other could result in massive volatility swings in just a few minutes. On the flip side, perhaps it’s a good thing that because it was computers, a circuit breaker of just five seconds was enough to stabilize things. Five seconds is barely long enough to register what your trading screen is telling you, let alone digest it and enter a trade. No wonder that the SEC report noted that in some ways the HFTs helped allevaite the impact of the crash (even though they might have contributed to it in the first place). There are problems with HFT (quote stuffing, for one. Another one is: If all trades are done by HFT - some reports put the average holding time for a stock at 22 seconds - who’s doing the fundamental analysis that is supposed to be behind true price discovery?), but as I said above, it’s more a problem of the implementation, not the idea. ---
**Author:** ![ralph124c](https://avatars.discourse-cdn.com/v4/letter/r/8797f3/32.png) [@ralph124c](https://boards.straightdope.com/u/ralph124c)\ **Post date:** [November 7, 2011, 5:43pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/123 "2011-11-07T17:43:31Z")
Remember the disaster called “Long Term Capital Management”? It was a fund that was started by Nobel prize-winning economists-they thought they had the key to risk-free investing. You needed $5 million to get in…so clearly the people who put their money in had their eyes open. Things were going great…until Russia defaulted on its bonds…then the whole pile came crashing down. Eventually, the US Treasury had to bail them out. What social utility did LTCM accomplish? ---
**Author:** ![yelimS](https://avatars.discourse-cdn.com/v4/letter/y/54ee81/32.png) [@yelimS](https://boards.straightdope.com/u/yelimS)\ **Post date:** [November 7, 2011, 6:04pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/124 "2011-11-07T18:04:54Z")
> [@DragonAsh](#): > > Well, there are other things, of course, but in a nutshell, yes: The primary market would probably not exist if there wasn’t a liquid secondary market. And it starts even before that. Many companies would never get off the ground it if wasn’t for angel/venture capital/private equity financing. Venture capital funds, for example, are willing to take a complete loss on 90% of their investments, because they expect/hope to recoup all that and more from the successful 10%. In those cases, the common exit strategy is usually an IPO - think Google, which started out with a $100,000 investment - or being acquired by another company - think Skype and eBay. And all of that depends on an active, liquid secondary market, for the reasons noted above. > You’ve gotten this turned around - everyone that participates in the secondary market is helping the market serve the function! By restricting access, you cripple the very function we want the market to serve. I guess I just don’t quite understand what you’re actually objecting to? Who do you think isn’t ‘justified’ in earning money from the stock market? You misread me - I’m not asking whether liquidity is a good thing (agreeing to that by now), but I’m asking whether there is a thing such as sufficient liquidity, at which point any additional liquidity (and hence, making money generating it) is just a waste. If it is, I’m not sure at all how one should regulate it, but at least we could conclude that there are more constructive things to do than entering a saturated market, so to speak. From your second paragraph it seems you think more liquidity is always good, but to me, it just looks like unsubstantiated opinion. > [@DragonAsh](#): > > Re day traders - what possible reason would you suggest for limiting this? I was under the impression that day traders increase volatility, perhaps out of proportion with the benefit they serve. I suppose the problem (under) with HFT applies to them a bit, too - not sure. > [@DragonAsh](#): > > There are problems with HFT (quote stuffing, for one. Another one is: If all trades are done by HFT - some reports put the average holding time for a stock at 22 seconds - who’s doing the fundamental analysis that is supposed to be behind true price discovery?), but as I said above, it’s more a problem of the implementation, not the idea. That’s the impression I’ve gotten with HFT so far - that while it does add to liquidity, it works on factors that really shouldn’t affect the value of a company. As you say, it might be a problem with implementation, not the basic idea, but some more regulations could still be in order? Thanks again for a good reply, by the way. ---
**Author:** ![Ravenman](https://sea3.discourse-cdn.com/straightdope/user_avatar/boards.straightdope.com/ravenman/32/2929_2.png) [@Ravenman](https://boards.straightdope.com/u/Ravenman)\ **Post date:** [November 7, 2011, 6:09pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/125 "2011-11-07T18:09:42Z")
> [@ralph124c](#): > > What social utility did LTCM accomplish? Are you contending that the Vanguard growth-oriented, no-fee mutual fund that Joe Blow invests his IRA in is substantively no different than LTCM? If one were to concede that LTCM did not serve a social purpose, is that lack of social purpose also applicable to mutual fund managers? ---
**Author:** ![Evil\_Captor](https://avatars.discourse-cdn.com/v4/letter/e/f17d59/32.png) [@Evil\_Captor](https://boards.straightdope.com/u/Evil_Captor)\ **Post date:** [November 7, 2011, 6:21pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/126 "2011-11-07T18:21:35Z")
> [@DragonAsh](#): > > You’re equating financial industry workers to arsonists? Nice. They DID sorta burn a lot of money back in 2008. ---
**Author:** ![Trom](https://avatars.discourse-cdn.com/v4/letter/t/958977/32.png) [@Trom](https://boards.straightdope.com/u/Trom)\ **Post date:** [November 7, 2011, 6:33pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/127 "2011-11-07T18:33:45Z")
> [@DragonAsh](#): > > … > There are problems with HFT (quote stuffing, for one. Another one is: If all trades are done by HFT - some reports put the average holding time for a stock at 22 seconds - who’s doing the fundamental analysis that is supposed to be behind true price discovery?), but as I said above, it’s more a problem of the implementation, not the idea. Most HFT programs are market makers. In general, market makers aren’t looking at fundamentals at all. They are trading based on order flow, other quotes, volume, statistical relationships to other instruments, etc. That isn’t to say they function outside of the fundamental traders’ view of the market. For example, rather than look at a balance sheet and decide that a stock is underpriced, they observe a barrage of aggressively priced buy orders come to the market, and, using that technical information, adjust their quotes higher. Their “customers” are the fundamental traders - who really move the market. I’d actually be surprised if the average holding period is 22 seconds. I would think it would be lower. There’s a lot of potential directional exposure when holding for 22 seconds! ---
**Author:** ![ralph124c](https://avatars.discourse-cdn.com/v4/letter/r/8797f3/32.png) [@ralph124c](https://boards.straightdope.com/u/ralph124c)\ **Post date:** [November 7, 2011, 6:57pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/128 "2011-11-07T18:57:06Z")
> [@Ravenman](#): > > Are you contending that the Vanguard growth-oriented, no-fee mutual fund that Joe Blow invests his IRA in is substantively no different than LTCM? If one were to concede that LTCM did not serve a social purpose, is that lack of social purpose also applicable to mutual fund managers? In my opinion, hedge funds like the 25:1 leveraged LTCM fund have the potential to cause lots of damage. This fund was set up to exploit small differences of assets in different markets-when that didn’t work, they wound up setting up very highly leveraged investments. It was nothing more than a (more sophisticated) version of a Las Vegas casino. Did it cause others (other than the original investors) lots of grief and losses? Yes. ---
**Author:** ![DragonAsh](https://avatars.discourse-cdn.com/v4/letter/d/db5fbb/32.png) [@DragonAsh](https://boards.straightdope.com/u/DragonAsh)\ **Post date:** [November 7, 2011, 7:40pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/129 "2011-11-07T19:40:31Z")
In answer to question about ‘a sufficient level of liquidity’, I haven’t given this a lot of deep thought yet, but my instinct says, no, such a concept doesn’t exist. Reason being, doesn’t matter where you place the bar, you’re introducing the idea of scarcity - you’re esssentially saying ‘at some point, this will be all the shares that can trade’. I don’t see how an artificial, forced scarcity could work while still retaining the benefits of free-market liquidity. > [@ralph124c](#): > > Remember the disaster called “Long Term Capital Management”? > It was a fund that was started by Nobel prize-winning economists-they thought they had the key to risk-free investing. > You needed $5 million to get in..so clearly the people who put their money in had their eyes open. > Things were going great..until Russia defaulted on its bonds..then the whole pile came crashing down. > Eventually, the US Treasury had to bail them out. > What social utility did LTCM accomplish? Remember? Um, pretty well, actually. It’s kinda my field after all. The most well-known quote about LTCM is the idea that the company was ‘picking up pennies in front of a bull-dozer’. It’s not necessarily far from the truth - but LTCM’s trades were not, in and of themselves, all that risky. The trades were arbitrage trades - taking advantage of minute mis-pricings between instruments. They’d buy the ‘underpriced’ security and sell the ‘overpriced’ security, and wait for the price difference between the two to converge, then reverse the trades to close the position. This remains one of the most common trading strategies used by prop desks all over the world. LTCM was mostly (especially at first) involved in government debt - they’d buy the just-off-the-run bond (slightly old) bond, and sell the on-the-run (just issued) bond, because often these instruments were slightly mis-priced due to differing liquidity issues. Razor, razor-thin margins, so you need to be in REALLY big trades to make any serious money. LTCM went bust because it was massively over-leveraged when Russia defaulted on its bonds (and its major bond positions expected a convergence in prices of US/EUR and JPN bonds; instead spreads widened), and investors started demanding their money back. Ironically, the trades themselves were sound, if LTCM hadn’t been over-leveraged - it’s often forgotten that the rescue package netted a profit to the firms that participated. Another irony: Bear Stearns was the only major city bank that declined to take part in the LTCM rescue deal. Wall Street got its payback in 2008… So once again, we have a problem with the implementation, not the idea. The idea was probably sound. Being massively over-leveraged probably wasn’t. But what about social value? As I’ve repeatedly said - you can’t isolate one part of the system and decide ‘this part isn’t beneficial to society’. Airplanes crash and kill hundreds of people, but we don’t decide that the entire aviation industry has no social value. Massive defaults and bubbles certainly aren’t new - I dont’ think there were any hedge funds when tulip mania was all the rage in early 1600s Europe. As long as there are people, and there is fear and greed, there will be market busts. I’m not disagreeing that we always need to do better at implementation - airplanes might still keep crashing, but that doesn’t stop us from trying to figure out how to make planes safer. Sadly, it’s usually only from such disasters that we learn the lessons we needed to learn. And in some cases, even repeated thumpings over the head doesn’t help (at some point you’d figure that companies would realize that being over-leveraged was really really bad :smack:) Still, I’d argue that, even with the busts, our lives are better off. Just one example: When’s the last time you had to physically set foot in a bank? I recently bought a new car (2011 Mini Countryman, love it!), tweaked my life insurance and will (my daugher was born five days ago; really do need to come up with a name) and paid for my fantasy football league run by a guy in the US, for a league with members all over the planet - without once having to write a check or set foot into a bank, insurance company, or car dealer. How cool is that? ---
**Author:** ![Ravenman](https://sea3.discourse-cdn.com/straightdope/user_avatar/boards.straightdope.com/ravenman/32/2929_2.png) [@Ravenman](https://boards.straightdope.com/u/Ravenman)\ **Post date:** [November 7, 2011, 7:55pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/130 "2011-11-07T19:55:23Z")
> [@ralph124c](#): > > In my opinion, hedge funds like the 25:1 leveraged LTCM fund have the potential to cause lots of damage. This fund was set up to exploit small differences of assets in different markets-when that didn’t work, they wound up setting up very highly leveraged investments. > It was nothing more than a (more sophisticated) version of a Las Vegas casino. > Did it cause others (other than the original investors) lots of grief and losses? Yes. Sooo… was my question not clear, or do you just not want to answer it? Does an equities trader who works for a mutual fund also not serve any social utility? ---
**Author:** ![JohnT](https://sea3.discourse-cdn.com/straightdope/user_avatar/boards.straightdope.com/johnt/32/15048_2.png) [@JohnT](https://boards.straightdope.com/u/JohnT)\ **Post date:** [November 7, 2011, 7:58pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/131 "2011-11-07T19:58:18Z")
> [@ralph124c](#): > > Remember the disaster called “Long Term Capital Management”? > It was a fund that was started by Nobel prize-winning economists-they thought they had the key to risk-free investing. > You needed $5 million to get in..so clearly the people who put their money in had their eyes open. > Things were going great..until Russia defaulted on its bonds..then the whole pile came crashing down. > Eventually, the US Treasury had to bail them out. > What social utility did LTCM accomplish? Actually, the Treasury did not bail out LTCM, a consortium of banks and investment firms did. Also, the fund was not started by Nobel prize-winning economists, it was started by ex-Solomon bond trader John Meriwether, who recruited Merton and Scholes to be members of the Board of Directors. Merton and Scholes were not Nobel prize winners until 1997, 4 years after they began their involvement in LTCM. ---
**Author:** ![yelimS](https://avatars.discourse-cdn.com/v4/letter/y/54ee81/32.png) [@yelimS](https://boards.straightdope.com/u/yelimS)\ **Post date:** [November 7, 2011, 8:34pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/132 "2011-11-07T20:34:24Z")
> [@DragonAsh](#): > > In answer to question about ‘a sufficient level of liquidity’, I haven’t given this a lot of deep thought yet, but my instinct says, no, such a concept doesn’t exist. Reason being, doesn’t matter where you place the bar, you’re introducing the idea of scarcity - you’re esssentially saying ‘at some point, this will be all the shares that can trade’. I don’t see how an artificial, forced scarcity could work while still retaining the benefits of free-market liquidity. Again, I’m not asking what could be done, just concerned with ethics here. Even if there are no regulations that can effectively keep speculation at a level where liquidity is just where we need it and not above, we can still imagine that an ethically minded person would decide that he would not contribute to society by speculating in stock at this point. By the way, and this is a general question to everyone - do you agree in what’s been my premise for this thread, that to deserve the money you earn, you have to add value to society, not just find a clever, legal way to redistribute them to yourself? And also, that representing a fund is no different in principle than representing yourself, as long as you’re redistributing, not adding, value? ---
**Author:** ![ralph124c](https://avatars.discourse-cdn.com/v4/letter/r/8797f3/32.png) [@ralph124c](https://boards.straightdope.com/u/ralph124c)\ **Post date:** [November 7, 2011, 9:00pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/133 "2011-11-07T21:00:06Z")
My point about LTCM is that this speculation was financed by some of the richest people in the world. If they were willing to risk the loss of their own money, that is fine with me. But the disruption of the capital markets CAUSED by these fools (the LTCM managers) impacted people who had nothing to do with it…and stood to gain nothing from its actions. What about a company that wanted to issue stock, so as to expand their plant and hire people? The downturn caused by the failure of LTCM certainly impacted them…and in a bad way. So I see little benefit to allowing a bunch of millionaires to screw around for their own fun and profit, and then ask the Federal taxpayers to clean up the mess they made. How would you like it if somebody boght up your companie’s stock, then took over and fired you-so that they could sell off the company in bits and pieces (and make a killing)? To say that the actions of firms like LTCM are benign is very naive. ---
**Author:** ![JohnT](https://sea3.discourse-cdn.com/straightdope/user_avatar/boards.straightdope.com/johnt/32/15048_2.png) [@JohnT](https://boards.straightdope.com/u/JohnT)\ **Post date:** [November 7, 2011, 9:27pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/134 "2011-11-07T21:27:52Z")
That’s all fine, but: 1. The LTCM problem did not require “the Federal taxpayers to clean up the mess they made”, and, 2. If you didn’t notice, there was a [dot.com/IPO](http://dot.com/IPO) boom going on in the late 90s, one that was not stopped by the LTCM problem. [http://www.tradersnarrative.com/will-the-ipo-drought-end-in-february-2009-2248.html](http://www.tradersnarrative.com/will-the-ipo-drought-end-in-february-2009-2248.html) ---
**Author:** ![Trom](https://avatars.discourse-cdn.com/v4/letter/t/958977/32.png) [@Trom](https://boards.straightdope.com/u/Trom)\ **Post date:** [November 7, 2011, 9:47pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/135 "2011-11-07T21:47:15Z")
**YelemS** - I highly recommend the book [Trading and Exchanges: Market Microstructure for Practitioners](http://www.amazon.com/Trading-Exchanges-Market-Microstructure-Practitioners/dp/0195144708) by USC professor Larry Harris. I read it a couple years ago, and I found it very informative. He goes into pretty much everything that’s been brought up in this thread. I’m just now browsing through his academic papers on his website. I haven’t read it yet, but [this](http://www-bcf.usc.edu/~lharris/ACROBAT/Zerosum.pdf) (pdf) paper looks like an interesting read while I make dinner tonight. > [@](#): > > Our study will examine many different trading styles. Trading styles generally are associated with specific types of traders. We shall consider the styles of value-motivated traders, inside informed traders, headline traders, event study traders, dealers, market-makers, specialists, scalpers, day traders, upstairs position traders, block facilitators, market data monitors, electronic proprietary traders, quote-matchers, front-runners, technical traders, chartists, momentum traders, contrarians, pure arbitrageurs, statistical arbitrageurs, pairs traders, risk arbitrageurs, bluffers, “pure” traders, noise traders, hedgers, uninformed investors, indexers, pseudo-informed traders, fledglings and gamblers. **We will describe each of the traders, explain how their trading generates profits or losses, and consider how the affect price efficiency and liquidity.** Note that the article is from the 90s. Most of these traders are still around, but have been automated (HFT-ized). It’d be interesting to find an updated version. ---
**Author:** ![yelimS](https://avatars.discourse-cdn.com/v4/letter/y/54ee81/32.png) [@yelimS](https://boards.straightdope.com/u/yelimS)\ **Post date:** [November 7, 2011, 10:16pm UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/136 "2011-11-07T22:16:11Z")
Noted, thanks! ---
**Author:** ![DragonAsh](https://avatars.discourse-cdn.com/v4/letter/d/db5fbb/32.png) [@DragonAsh](https://boards.straightdope.com/u/DragonAsh)\ **Post date:** [November 8, 2011, 12:24am UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/137 "2011-11-08T00:24:32Z")
Trom, that’s an excellent book, by and large. Slightly out-dated - I think the bulk of Larry’s research was done in the 80s and 90s? - but it’s an excellent primer. It was one of the reference books I used in a course a few years back, I think it’s in a box somewhere back home. ---
**Author:** ![Evil\_Captor](https://avatars.discourse-cdn.com/v4/letter/e/f17d59/32.png) [@Evil\_Captor](https://boards.straightdope.com/u/Evil_Captor)\ **Post date:** [November 8, 2011, 12:29am UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/138 "2011-11-08T00:29:40Z")
> [@aux203](#): > > You cut and paste that from wikipedia, didn’t you? /me looks at the link he posted. “It appears that I did,” he said drily. > [@](#): > > The rest of that page explains a lot of these issues. As usual, this conversation has veered off topic. Initially you expressed concern that the notional value of the derivatives market was so large. This is a common response when people have no real idea of derivatives are or what they do. I know what derivatives are and what they do. I am sorry you are not alarmed by them. Other people are. Big name economists, Warren Buffet, etc. If you have a logical argument why derivatives are not disastrously dangerous, bring it. But first explain how they played little or not role in the recent stock market crash, a point many economists and market analysts would strongly disagree with. Perhaps you mean SOME flavors of derivatives are harmless, while others are extremely dangerous. Is that your position? > [@](#): > > Rand Rover gave an example, here are some more examples for people who are totally lost: > > An example of a derivative might be an option to buy 100 barrels of oil at 100$ at some point in the future. The notional value of this contract is 10,000$. But an option to buy 10,000$ worth of oil is not the same as actually owning 10,000$ worth of oil. Note that multiple derivative contracts can be applied to the same asset. Quite a lot of these contracts in effect cancel each other out. > > A large portion of the derivative market also includes interest rate swaps. Two parties might exchange interest rate cash flows based on some notional principle amount. You might pay a fixed rate to someone else while they pay you a rate that varies. This can be handy to defray risk associated with fluctuating interest rates. It can also be a tool for speculation. This “principle” amount might be 10 million dollars but it’s not as though 10 million dollars is changing hands. It’s merely the number used to calculate the interest. But the notional value of this contract would be 10 million dollars. So when a trader makes a derivative wager, all that is at stake is the money his is wagering, the amount of the financial original instrument is irrelevant? Why then were derivatives an issue in the recent market crash? > [@](#): > > Sigh. Which not to say that derivatives don’t have their problems. But I agree with DragonAsh. The level of financial knowledge on this thread, and this board for that matter, amazes me. I can only assume it’s lower among the general public. Most people don’t have a prayer of understanding even basic finance. I don’t know what the answer is or if we should even try to find one. If you can’t add to the discussion without rolling your eyes at the amount of knowledge other people have on the topic, it would be perfectly all right with me if you did not contribute at all. The amount of self-important chest-puffery in this discussion amazes me. ---
**Author:** ![JohnT](https://sea3.discourse-cdn.com/straightdope/user_avatar/boards.straightdope.com/johnt/32/15048_2.png) [@JohnT](https://boards.straightdope.com/u/JohnT)\ **Post date:** [November 8, 2011, 4:42am UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/139 "2011-11-08T04:42:47Z")
> [@Evil\_Captor](#): > > So when a trader makes a derivative wager, all that is at stake is the money his is wagering, the amount of the financial original instrument is irrelevant? Why then were derivatives an issue in the recent market crash? Their complexity. The Eyes of Satan The above image is taken from page 200 of Nicholas Dunbar’s [The Devil’s Derivatives](http://www.nickdunbar.net/?page_id=8), in my opinion one of the finest books written about the 2008 crisis. (Sorry for the sucky scan, but it came out clean enough imho.) Each of the dots around the edge (and the dots in the middle) represent _other CDO’s_ which made up this particular derivative (This derivative is represented by the dot in the middle of the Eye.) Not shown in this picture are the hundreds of mortgage bonds (which, in turn, represent the tens-of-thousands of mortgages that make up the assets of the bonds, from which the value of the derivatives are derived.) While there were problems in the market prior to September 8th, the official collapse of Lehman Brothers (LB) on that date meant that some of these “dots” were now worthless, the assets behind them either tied up in bankruptcy court, or seized by other counterparties. Trying to figure out which of the outside dots were LB-backed CDO’s (or which of _those_ dots had LB mortgage bonds within them), was a horrendously difficult task just for this one CDO-cubed derivative. Multiply that by _every derivative in the world which may or may not have had LB-backed assets_, and it’s no wonder that the markets froze - nobody knew what their exposure was to LB, which meant that nobody had any idea what the value/price of the CDO should be! ---
**Author:** ![septimus](https://sea3.discourse-cdn.com/straightdope/user_avatar/boards.straightdope.com/septimus/32/410_2.png) [@septimus](https://boards.straightdope.com/u/septimus)\ **Post date:** [November 8, 2011, 7:57am UTC](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864/140 "2011-11-08T07:57:58Z")
One advantage of liquidity and derivatives, as others have pointed out, is _Price Discovery_, or helping the market form “correct” opinions about a business’s future value. That a large marketplace, mainly composed of ignorant (and not always even rational) players, can estimate such values fairly accurately is almost an interesting “paradox.” Much investment is by index funds, or investors who imitate to varying extents the ideas of such funds. These funds assume, in effect, that the market’s opinion is correct (at least until S & P revises its index list). But I hope it’s clear that if 100% of a market believes the “efficient market hypothesis”, than that hypothesis will cease to be true ! Thus, one could argue that index funds are a disservice to efficient pricing, and that contrary speculators thus perform a good service. Unfortunately, most of the speculation in today’s stock markets isn’t about predicting the dollar changes in stock prices, years down the road, due to insights about the business or the economy. Instead it’s about predicting the penny changes in stock prices, seconds down the road, due to insights about other computer programs engaged in high speed trades. Is no one here familiar with the concept of _Diminishing Returns_? Liquidity (and to some extent, derivatives) play a role like lubricant, or perhaps even the vegetable oil I put in the skillet before frying eggs. But if that oil is “good,” it doesn’t follow that “the more the better,” that I should immerse my egg in a liter of oil before frying it! Yet some here almost seem to be arguing that way. Not all returns diminish, obviously. Eating two eggs and two strips of bacon, many answer “Yes” when asked if they want another egg and more bacon. But even these gluttons don’t want their eggs drenched in oil. > [@puddleglum](#): > > Liquidity is very useful because it allows more people to invest and make investments. Yeah, we know. BTW, how much oil do you use when you’re frying eggs? > [@JohnT](#): > > However, the price of the stock, which is determined by traders, reflect this news without the company having to do anything. Yeah, we know about price discovery. Are you claiming the “traders” who hold a stock for less than one second play an important role in pricing such news? Care to comment on how you fry your eggs? > [@puddleglum](#): > > If it makes you feel any better realize that day trading stocks for money is phenomenally difficult and that most who attempt it quickly lose their shirt. There are major Wall Street firms, with thousands of employees and expensive high-speed electronics, engaged in “day trading” (or should it be called “second trading” 😃 ). Do you think these people are losing their shirts? And, BTW, I’m glad that this thread hasn’t degenerated into another “Why do you hate successful people?” thread, but the defense that “most” day traders lose, if anything, helps OP’s case … unless you impugn pseudo-communist hate-the-successful motives to him. > [@msmith537](#): > > Really what traders are doing is creating markets and looking for inefficiencies, thus making them more efficient. It benefits the rest of us because economies work more efficiently and more wealth is created when goods and services can be readily bought and sold. > > Now stop hating on money! And how much oil do you use to fry eggs? And did I speak too soon (“stop hating on money”) when I expressed thanks just above? > [@Trom](#): > > Now imagine a more liquid market… Yeah. Everyone has already conceded that liquidity is good. The question is whether there are “diminishing returns” from excessive speculation. The answer (which allows the marketplace to answer the question) is to impose a modest transaction tax on share trades. Upthread, I think I saw mention that there was already a tax on trades. Is it $19 per million shares? If so, **Trom** , do you find that tax too little, too big, or just right? > [@DragonAsh](#): > > :rolleyes: > > You clearly don’t have the first clue about what derivatives actually are or how they are used. You do know that Mr Buffet himself also trades in derivatives, his rhetoric notwithstanding? Do you know why? Because used correctly, derivatives are damn useful. > > Fire can help provide warmth, food, and energy. You wouldn’t ban fire just because it can also burn your house down. > > The overall level of misinformation, misunderstanding and general ignorance in this thread is so off the charts I can’t quite wrap my head around it. Oh. if I would point to the most egregious misunderstanding in the thread, I would point to the Dopers who thought (or pretended to think) that **Evil Captor** doesn’t understand derivatives. I sympathise with Mr. Captor, recalling the time on another board I wrote “free health care” when I meant “taxpayer-finances health care” and an asshole pretended to believe I thought doctors’ and nurses’ salaries grew on magical trees. PLEASE, people. We’re all intelligent adults. You’ll lose my respect, anyway if, to “score debating points,” all you can do is pretend to think your debating opponent is an idiot. And, BTW, the “nominal value” of a derivative is far from irrelevant; AIG wrote insurance policies for far more than its worth, and unlike insuring ships, which don’t _all_ sink at once the risk they assumed was inappropriate … or rather quite attune with modern Wall Street practices: “Heads we win, tails the taxpayer loses.” > [@DragonAsh](#): > > During the crash - which, remember, only lasted about four minutes - stocks such as Procter & Gamble and Accenture were quoted at prices as low as $0.01, or as high as $100,000. We can only assume some traders made a small fortunate picking up stocks worth $40-50 for a penny. Why the crazy quoted prices? I have no expertise in market operations. But this anecdote doesn’t strike me as supporting a position that _unlimited computerized speculation is good_. > [@DragonAsh](#): > > In answer to question about ‘a sufficient level of liquidity’, I haven’t given this a lot of deep thought yet, but my instinct says, no, such a concept doesn’t exist. Reason being, doesn’t matter where you place the bar, you’re introducing the idea of scarcity - you’re esssentially saying ‘at some point, this will be all the shares that can trade’. I don’t see how an artificial, forced scarcity could work while still retaining the benefits of free-market liquidity. No need to “enforce scarcity.” A very small transaction tax, while not a panacea, would be a good step. [Previous page](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864.md?page=6) [Next page](https://boards.straightdope.com/t/whats-the-benefit-to-society-of-stock-speculation-edited-title/601864.md?page=8)