Speculation in Finance Explained for Dummies

What is speculation?

In finance, speculation, also known as speculative trading, refers to the act of buying a financial instrument, an asset, currency, or commodity with the expectation that the value of the purchase will increase in the future.

However, a financial transaction based on speculation involves a substantial risk that the speculator will incur a significant loss if the value of the asset decreases in value.

Collins Dictionary describes speculation as ‘the act of making very risky investments[1] in the hope of large gains,’ while the Oxford Dictionary defines it as ‘the activity of buying and selling goods or shares in a company in the hope of making a profit, but with the risk of losing money.’

The term ‘speculation’ originates from the Latin word ‘speculatus,’ which means ‘to spy out’ or to ‘examine.’

Noteworthy, the following sayings with regard to speculation in finance:

• ‘Speculation is only a word covering the making of money out of the manipulation of prices, -instead of supplying goods and services.’ (Henry Ford (1863 – 1947) – founder of the Ford Motor Company.)
• ‘The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is cause for concern.’ (Benjamin Graham (1894 – 1976) – economist and investor.)
• ‘The biggest point of speculating with your stock investments is that you’re putting your money where you think the rest of the market will be putting their money.’ (Dummies.com)
• On a humorous note: ‘There are two times in a man’s life when he should not speculate: when he can’t afford it, and when a can.’ (Mark Twain (1835 – 1910) – American writer and humourist.)

Speculators

People who engage in speculation on financial markets are called speculators.

Characteristics of speculators are, amongst other attributes:

• Apply a technical analysis of price actions on financial markets more frequently than fundamental analysis of a financial instrument.
• Prepared to take significant investment risks.
• Seek to profit from short-term price fluctuations on financial markets and not interested in a long-term investment strategy. Hence, not keen to hold a security or currency for a lengthy period.
• Prepared to trade in both bear and bull markets, meaning equally comfortable with both buying long and selling short.

Types of speculators

Basically, there are two types of speculators:

• Bullish speculator

A bullish speculator trades with the expectation that the price of a security, commodity, or currency will increase, enabling him or her to sell it at a higher price in the future.

• Bearish speculator

Contrarily to a bullish speculator, a bearish speculator expects the prices of securities, commodities, or currencies to decrease. Put differently, a bearish speculator sells short financial instruments with the goal to buy them back at a lower value at a time in the future.

In addition, accountlearning.com identifies two more types of speculators, namely:

• Stags

In comparison with bullish and bearish speculators, stags are considered cautious investors, who apply for shares in new companies with the only aim to sell them at a premium or profit as soon as the shares are allocated.

• Lame ducks

A lame-duck refers to a bearish speculator who is unable to meet his or her commitment immediately, struggling like a lame duck.

Speculation in the markets

Speculation in the forex market

The forex market, also called the currency market, attracts a large number of speculators because of, inter alia, the following features:

• The occurrence of constant fluctuations in the exchange rates between currencies.
• The high amount of leverage available that enables traders to generate significant gains, using only small amounts of capital to trade with.
• Frequent trading opportunities because of the availability of various currency pairs.

Speculation in the stock market

In stock markets, also called stock exchanges, shares considered extremely risky are referred to as speculative shares or speculative stocks.

Typically, speculative shares offer potentially high returns, compensating for the high risks that accompany them.

Shares of small companies trading at low prices, referred to as penny stocks, are an example of speculative shares.

A number of speculators in stock markets execute intraday trading strategies, aiming to profit from intraday fluctuations in share prices.

Speculation in the commodity market

Speculators play a significant role in the commodity market in numerous ways:

• Speculators increase the number of traders in the commodity market, helping to control the price volatility of commodities.
• They add more liquidity to the market, stimulating trading among all the participants in the market.
• By increasing the number of traders (who hold a variety of trading positions) to a great extent, speculators help to prevent market manipulation.
• Prices of commodities are impacted by speculators in a way that prevents considerable price swings by utilising futures contracts to motivate buyers to stockpile commodities in order to prevent shortages.

Speculation in the bond market

Speculators are also active in the global bond market, comprising bonds issued by governments and large corporations.

Advantages of speculation

Adding market liquidity

Speculators add liquidity to markets through their active trading. The absence of speculators would cause illiquid markets in which large spreads between bid and ask prices would feature, making it difficult for investors to purchase or sell investments at a fair market price.

Stimulating the economy

Speculators, with a greater capacity for investment risk, are more prepared to invest in unproven securities and companies than more conservative investors.

Speculators enable young and new companies to expand or support temporary failing businesses to weather a financial storm.

In the ways mentioned above, speculators help to stimulate and grow the economy.

Disadvantages of speculation

Economic bubbles

Unbridled speculation may cause economic bubbles, created by prices that are rising unrealistically high.

Pushing prices to unreasonable levels

Sometimes, speculation can drive prices to unreasonably high levels that do not accurately reflect security or an asset’s true intrinsic value.

This scenario may lead to price fluctuations that, although temporary, can have a long-term effect on the financial well-being of a business or the stability of a country’s economy.

[1] Accentuations in quotations and sayings in the article are by the article writer.