What Speculators Do

In the commodities markets, producers sell their product months (even years) in advance (through "futures contracts"). This helps producers plan, because they know they will receive a certain price for their efforts. Suppose that you are a farmer, and you have the choice of growing wheat or corn. Which should you plant? How do you know what the price of either will be when the harvest comes? Maybe there will be a bumper crop of one, and a near famine in the other. But which? And, how much should you spend on fertilizer? Or is the farm land even worth keeping as farm land, given the return you might or might not get? All of these questions can be quickly answered if you look up the price of the corn and wheat futures. If the going rate for corn at harvest next year is high, and wheat is low, not only do you choose the right crop, but you can answer the other questions as well.

So, who is buying these things? Again, suppose you are a company that makes corn flakes. You need wheat to do it. And, you've been burned in the past when you thought you would be able to make money, but couldn't because the wheat crop failed and you had to pay way more than you expected and lost money on every box of cereal you sold. On the other hand, some years you got lucky, and got a really good deal on wheat, but all things considered, you'd really just like predictability and a nice steady profit. Why not buy wheat years in advance for known prices? Then you can plan around it, and not have to worry about the unexpected.

But, suppose you weren't a factory owner, but a wizard weather predictor. Your models are telling you that a big drought is coming, and that the corn crop is going to be terrible. You might make some money if you bought some corn futures before anyone else realized the doom on the horizon. Then, when everyone realized there wasn't going to be enough corn, and the price went went way up, you could sell the corn you bought cheaply for a nice, fat profit. You would be speculating on the future of wheat.

There is a danger, though, that truckloads of corn are going to show up at your doorstep one Saturday, and that would not be good. So, you've got to make sure and sell the futures contract you bought (hopefully at a profit) before the contract is due.

And, here is the key: at the end, right before the contract comes due, the contracts all have to find a home for receiving the product. Then, it is a simple matter of supply and demand, and the fact that the futures contract went up and down for months on the market is irrelevant. If there is a lot of corn, the price will go down, and if there is not, the price will go up. But, this is only reflecting real world supply and demand, and not crazy speculation (as might have been the case months before the contract was due, and it wasn't clear just how much corn would be around).

So, to quickly sum up, the point of the futures markets is to bring everyone's predictions of the future together for planning purposes. The speculators help allocate resources in the future. Think about it: if the futures price for wheat is high, farmers will plant more wheat, which will cause the futures prices for wheat to fall. In that case, the futures market predicted a shortage of wheat that was avoided because of their prediction.