Last time, we had mentioned that what makes the stock market unique is that no matter who is selling or buying, there is always a person on the other side. It is the much-maligned traders/speculators who impart this liquidity to the stock market. This week, we delve deeper into the role of a speculator/operator.
“The stock market is a dangerous place because of the existence of traders and speculators.” My mother used to tell me that the stock market is not the place for anybody’s hard earned savings. But after having invested in some good mutual funds a year back and seeing the returns, she now has a vastly improved opinion of the market.
But, mention trading and speculation and the thaw is instantly replaced by a chill. Images of the Big Bull, Nick Leeson, CRB, etc, etc, begin to loom large in her mind. Images of untold misery of thousands of small investors, caused by the actions of these speculators.
So, is all trading and speculation bad?
Or is mom missing the wood for the trees?
The truth is that in the stock market, everybody has a role to play, whether it be the small investor, the mutual fund, the FII or the much maligned operator/speculator.
Why speculators? Let us presume for a moment that the market is devoid of any traders and speculators. Then the market would be devoid of liquidity. In other words, it would be difficult to buy or sell stocks without significantly affecting the prices. Enter the speculator. He is willing to take more risks than your average investor; he is willing to buy stocks with a very short-time horizon—days, even hours perhaps. The speculator knows that daily price moves are as much a function of the daily sentiment as they are a function of the fundamentals of a company. And he looks to profit from them.
To understand this better, let’s peek into a typical day in the life of a speculator.
Bajaj Auto workers have gone on a strike and the price has fallen 8%. I bought Bajaj Auto just a week earlier and am starting to feel pretty sick. But the speculator…he begins to scent an opportunity.
Next morning: I’m heading for the exit…
The next day, the newspaper headlines scream out that Bajaj Auto’s EPS could fall 3% if this strike lasts more than 10 days. I can really feel a chill going down my spine. Oh my God! If this stock falls any further I would be sitting on a loss, I tell myself. But hey, I am a smart guy. So I’ll sell the stock today and wait for it to fall another 10-15% and then buy it back.
…while the speculator is moving in for the kill
Things are going according to plan. I place my order to sell at 10:00 a.m. sharp. The stock opens down 2%, but my broker has an order to sell at the market price and he promptly does so. Guess many other brokers had similar orders as well and soon the stock crumbles a further 8%. Now the speculator moves in for the kill. Fine, Bajaj Auto’s profits may drop 3% if this strike persists for more than 10 days. But the stock is down nearly 16% since the news came out. That may be justified if this strike last longer than 10 days. However, he feels the market has overreacted and starts to buy gradually at the lower circuit (the lowest price that the exchange permits the stock to fall on a day). In the process, he absorbs the selling pressure coming from some other friends of mine who called me in the morning and decided that my strategy was very wise indeed.
1.30 p.m.: The foreigner steps in…
It’s now 1:30 p.m. in Bombay; the stock is down only 7% and only some stray trades are taking place. A large foreign fund in London, which has been looking to buy Bajaj Auto for the last 6 months, senses an opportunity. This fund manager has a 5-year horizon when he buys a stock. As far as he is concerned, even if the strike were to persist for a month, the impact on the earnings of the company would be only a blip over the 5-year horizon he has in mind. He places his orders for a very, very large quantity of Bajaj.
…and the speculator’s eagle eye detects his presence
As his broker in Bombay starts buying, you can see some stirrings of life in the stock. It’s now up 2% from its low. Some more friends of mine think this is a heaven sent opportunity. When they had earlier reached me for advice, there were no buyers in the stock. Now there are buyers 2% above that price. Hallelujah! Promptly, they decide to follow me and place their sell orders too. Our speculator is watching the screen and he now senses that perhaps some other buyer in the stock has emerged. He offers a large-sized block on the screen (only a small portion of his total purchase, though). Immediately, somebody grabs it up. Now he is convinced that there is a buyer. He promptly buys back the small quantity he sold and then a little more. He senses the entry of a bigger fish.
Sometime later: more buyers in the ring
Shah and Sons is a venerable BSE broking house and has always been positive on Bajaj Auto ever since the stock traded in its late teens. It has a lot of clients who bought Bajaj Auto when it was in the late teens. Having become millionaires thanks to their investment in the stock, they have complete trust and faith in the ability of the company to make it through this strike. Shah & Sons recommends the stock yet again to its clients, who start to buy...
It’s 3.00 p.m.: the stock’s recovered…
The foreign fund is an unrelenting buyer and by 3:00 PM the stock is down only 1%, nearly 7% above its low for the day—which was when our speculator friend bought his stock.
…and ‘short-sellers’ are scurrying for ‘cover’
Enter the short-sellers. They are the guys who sell stocks they don’t have because they think the stock is going to fall. And when it does, they will buy the stock back (the jargon is “covering”). Some of them had sold the stock yesterday because they expected it to fall further. They were right. It did. Some have covered and booked their profits. But some have not. And now they want to do so too—might as well take home the meagre profit we are still making, they say to themselves. Some of my friends not only sold their existing holdings of Bajaj Auto but also went short (i.e., sold stock they did not possess) as they were very confident that the stock would drop further. As their brokers called them with the bad news that the stock had gained since they had short sold, they panicked and asked their brokers to buy back the stock they had sold short. For them, it is now only a question of reducing their losses on the short trade.
It’s closing time—and party time for the speculator
Now the action is really heating up. With just 15 minutes to go, the stock is now trading 1% above yesterday. Our speculator friend had made 9% in just a day. Meanwhile, some funds which have been sitting on the fence wondering when to make their purchases start feeling left out. They come rushing in to buy. Our speculator friend decides to cash in his chips. As these new funds and the shortsellers come charging in to buy, he starts to sell. For the next 15 minutes, the stock is extremely volatile, rising nearly 4% above yesterday’s close…the speculator sells all his stock.
Post script: not every day’s as good
It’s not always a happy ending like this for the speculator. Sometimes, he can be spotted drinking away his sorrows late into the night at Mahesh Lunch Home, in the vicinity of the BSE. But today he had a good day (calls for nothing but Geoffreys). He took a contrarian view (we would call it a common sense view) and profited from it. He provided an exit route for distressed sellers like me and provided supply to the few funds who came late to the party. In the process, he made a neat profit. But as I said earlier, sometimes he makes a loss as well.
So that then is the role of a speculator—he provides liquidity by buying when (nearly) everybody else wants to sell, and by selling when the opposite happens. In the process, he matches time horizons as well—my limited time horizon which made me decide to sell with the idea of buying back later, with that of our London-based FII who decided to buy with a 5-year view. He provided the liquidity. He did it because he knows that all the players in the market have different time horizons and expectations. He just helps bridge the gap.
After this, I hope you will all have something good to say about the speculator. Mom does!
(All characters and events in this write-up are fictitious. Any resemblance to real-life characters and/or events is purely coincidental.)
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