What is Speculation?
The word speculation can have several meanings, but when it is used in the context of the financial markets it has a very clear meaning. In the case of financial markets and trading, speculation is the act of conducting a trade or market transaction that has both the potential for a substantial profit and the possibility of a severe loss. In a speculative trade like this the trader believes that the potential for gain is more than enough to offset the risk of loss.
Any investor who is engaged in a speculative trade is probably keen to see the rapid price fluctuations in the asset being purchased or sold. In the case of speculation, traders can have a longer time horizon, although short-term speculation is more common. In the case of speculating on the changes in currency exchange rates we call it currency speculation. This is where a currency is purchased in the hopes that it will gain in value and can be sold later for a profit. This differs from currency exchange, aka Forex, that occurs to pay for some import, or finance a foreign investment or payroll.
If the speculative investment didn’t have the potential for significant gains there would be no motivation for anyone to engage in speculation. And sometimes it is difficult to see the difference between speculation and basic investing, although comparing the risk/reward ratio, the amount of leverage being used, and the expected duration of the trade can often provide clarity.
How Does Speculation Work?
One good example of the confusion that occurs when considering speculation versus investing comes from the real estate world, where property is often purchased with the intention of renting it to generate an income. While this would typically be thought of as investing, when it is taken to the extremes of purchasing multiple properties with minimal down payment and the intent to sell quickly for a profit, this is certainly considered speculation.
One of the benefits to having speculators in the market is that they bring liquidity and can help to narrow the bid-ask spread. In some assets speculative short selling keeps excessive bullishness in check and can help to prevent price bubbles from forming in the asset class. There are many forms of market speculation, and nearly any asset class, from stocks and bonds to cryptocurrencies and commodities, can be used to speculate.
Investing vs. Speculating
Normal traders and investors accept calculated market risk when they open their trades and attempt to profit from the price changes in the assets they are buying and selling. The primary difference between their investing and what is known as speculation is the amount of risk being undertaken. Any time money is spent on something with the expectation that it will rise in value this is considered investing. In this case the trader is taking on a calculated risk with a good probability of the investment returning a profit.
However, if the investment also has a high probability of failing this becomes speculation. There may still be a chance of success, and likely the possibility of a large profit, but the high chance of failure makes this speculation rather than investing. So, the basic difference between investing and speculating is the amount of risk in the trade. Very high-risk speculation is little different from gambling, while low risk investing uses the basics of market analysis to keep risk in check.
Arbitrage vs. Speculation
Investors will continually scan the market for profitable trades because that’s what investing and trading is all about. And in each case the trader uses a strategy that they know will work to generate profits. This strategy often takes a long time to develop and comes only with much practice and patience. One of the strategies often used in the markets to generate a profit is known as arbitrage. It is quite different when compared with speculation.
Arbitrage strategies are often used by large funds and institutional investors. It is preferred because it lowers risk substantially. Basically, arbitrage is an attempt to profit from the price difference of the same asset in two or more different markets. The arbitrageur will buy the asset in one market at a lower price and then sell it at a second market for a small profit. Because these price differences are typically small and fleeting, arbitrage is not really suitable for the individual investor. Speculation, on the other hand, is very suitable for the individual investor. Speculation doesn’t require large amounts of capital, and it can be carried out in nearly any market. While arbitrage limits risk it also limits profits. Speculation carries a greater chance of loss, but also a larger profit potential.
Speculation and the Forex Market
Forex trading markets trade roughly $6.6 trillion per day, making them the most liquid market in the world by far. Currencies are traded 24 hours a day, and prices can change rapidly in this global electronic marketplace. The forex market is dominated by the institutions and hedge funds, and many of the transactions made are spot trades to buy or sell currencies in order to conduct overseas business. Speculation in the forex markets is often hard to distinguish from normal hedging, where a company buys or sells a currency to protect against large market moves.
For example, a currency might be sold in order to protect against the price movements in a foreign bond. While some might consider this a hedge, in other cases it might be called speculation if the currency involved is quite volatile. It’s often hard to say what is simple trading and what is speculation in forex markets.
Speculation in the Stock Market
Speculation can also frequently be found in the stock market. As an example, consider the cannabis sector, where many of the stocks have a chance of skyrocketing in response to changing laws, but are also heavily leverage and could go bankrupt before such laws are passed. These stocks present great profit potential, but also the risk of great losses. Even so, some traders will be willing to speculate on the stock and buy it on a hunch or a feeling that things will turn out well.
Speculative trading has made some investors rich, but there are definitely pitfalls as well. For example, speculation can happen in sectors where prices are inflated on heightened expectations. As more investors crowd into the trade the trading volume also increases and a bubble begins to form. This is exactly what happened in the late 1990s when the dotcom boom was taking place. Eventually the bubble popped and after 2001 many speculators were wiped out as some stocks fell as much as 90% or more, and others were wiped out completely.
Types of Speculative Traders
There are many different types of speculative traders, but three well known trader types are the scalper, the day trader, and the swing trader.
Scalping is one form of speculation where the trader is focused on making many small profits over short time horizons. A scalper could place dozens of trades in a single day, collecting small profits from each. While many of the trades would be considered investing, there are cases where larger risks are accepted to find larger profits, making some scalping a form of speculation.
Day trading is also considered to be a form of speculation. Day traders are similar to scalpers, but they have a longer time horizon. Where scalpers might buy and sell the same asset within minutes, day traders could spend several hours in a trade. They do close their positions before the end of the trading day, and because they have no overnight risk, they can often accept larger risks on their trades, making them more like speculators.
And then there are the swing traders, who might hold a position for several day to several weeks. This type of trader can also become a speculator if they are purchasing an asset in the hopes it will increase dramatically over the coming weeks, while also accepting the risk that it could collapse if some bad news is issued.
Speculative Trading Strategies
There are many different ways for speculators to trade. Some of the most popular strategies used include price in action trading and the use of stop loss orders to enjoy some form of protection against massive losses. Pattern trading is also a type of trend trading, where price patterns are identified and used to find potential opportunities in the markets. This is strictly a technical analysis strategy that uses the historical performance of an asset to make a prediction regarding the future price movement of the asset. While some types of patterns are considered quite safe, others are more speculative in nature because they look to make large profits while taking on significant risks.
Stop loss orders are frequently used by speculators to minimize the losses they might suffer if price moves against them. Hedging can also be used as a form of protection when speculating on the price movements of a volatile asset.