Financial Market Speculation

“Modern usage has made the term ‘speculator’ a synonym for gambler and plunger. Actually, the word comes from the Latin ‘speculari’, which means to spy out and observe. I have defined a speculator as a man who observes the future and acts before it occurs. To be able to do so successfully – and it is an ability of priceless value in all human affairs – three things are necessary: First, one must get the facts of a situation… Second, one must form a judgment as to what those facts portend. Third, one must act in time, before it is too late…if action is delayed until the need is apparent to everyone, it will be too late.”

(Culled from: “My Own Story,” by Bernard Baruch).

What is Speculation?

In finance, the word “speculation” refers to the act of carrying out a financial transaction that has a possibility of losing value yet holds expectations of a significant gain. In other words, speculation means trading a financial instrument that has a high risk with the expectation of getting significant returns.

Who is a Speculator?

A speculator is a person who participates in speculative investments. A speculator buys assets, commodities, currencies, or other financial instruments with the intention of selling them at a profit at a later date. There is almost no difference between speculators and regular investors as they all participate in financial markets to make profits. However, there are certain differences that can differentiate a speculator from a regular investor. A speculator doesn’t pay so much attention to a company’s performance, whether good or bad, all he/she is interested in is how much profit they can make from a company’s stock. While regular investors are more concerned with the fundamental value of their investment.

Speculators are more involved in markets where price movements of securities are highly volatile and frequent. As a matter of fact, they play an important role in the market by curbing excess risks and ensuring that the required level of liquidity is maintained, by buying and selling when other investors are pessimistic about investing.

There are two major types of speculators: bullish and bearish.

The bullish speculators always expect that the prices of securities will rise with the hope of selling them at a profit in the future. While the bearish speculator is one who always expects that the prices of securities will fall in the future. Both types of speculators are readily available to trade in both bull and bear markets at any given time.

Understanding Speculation

Investors who buy speculative investments do so on price fluctuations. In that, the investors are more concerned with generating profit based on market value changes for that security on long-term investing. It is important to note that the risk associated with speculative investment is usually high.

There are also cases where foreign currency can be purchased on speculative investing, this is called ‘currency speculation’. What usually happens is that an investor buys a currency with the intention to later sell it at an appreciated price, unlike the typical investor who buys currency in order to finance a foreign investment or pay for an import. The difference between this type of investor is that one does it to make a profit while the other does it for business or personal reasons. 

Speculators play an important role in the markets, as they can provide liquidity and narrow the bid-ask spread. In turn, this will help producers hedge price risks more effectively. Another perk to market speculation is that it helps to keep the market’s bullish state in check from time to time and prevent asset price bubbles from forming. In a nutshell, there will be no need for speculation if there are no substantial gains involved.

Mutual funds and hedge funds also use speculation often to watch foreign exchange markets and bond markets. In the foreign exchange markets or Forex markets, the lines between speculation and typical can be a blur that makes it difficult for investors to differentiate the difference. This is what happens when a company or financial institution buys or sells a currency with the aim of hedging against market movements.

On a global level, the bond market has an estimated value of over $100 trillion, approximately $40 trillion of the total amount is based on the US bond market. The assets also include debt issued by the government and multinational organizations. In the bond markets, it is common to see asset prices fluctuate as they can be influenced by factors such as political and economic uncertainties. It is also often driven by common speculation.

In the stock market, stocks are commonly considered as high-risk investments. Speculative stocks, therefore, offer high returns as compensation for the high risks involved with the stocks. There are also penny stocks that have very low prices and are good examples of speculative stocks. 

A typical example of speculation

Sometimes, it is hard to differentiate speculation and a typical investment. For example, in real estate, it may be hard to differentiate between investment and speculation if a property is purchased with the intention of renting it out. Typically, buying a real estate property and renting it out is an investment, it can become speculation if multiple properties are purchased with minimal down payments for the sole purpose of reselling them as soon as possible for profit.

Advantages of Speculation

• Improves the welfare of the economy
• Enables market liquidity
• High-risk tolerance 

Disadvantages

• High risk
• Unreasonable prices
• Formation of economic bubbles