What is speculation?
Ready to roll the dice on the stock market? In finance, taking big risks is known as speculation. Traders who speculate invest in assets that are likely to generate big gains, as well as big losses. Speculative traders and investors, or speculators, buy an asset in the hope that its value will increase in the short term. Conversely, they might also invest in the hope that an asset will lose value, which is a practice known as short selling.
Unlike fundamental analysis, speculators tend to focus only on price movement. On the stock market, they pay little attention to earnings reports, analyst estimates or any other company history. Instead, their goal is to make a quick profit by entering and exiting a stock, which inspired the term “quick money.” Often they do this through technical analysis, such as chart reading.
You could say that speculators are the antithesis of Warren Buffett, “the Oracle of Omaha,” who invests for the long term in companies that typically trade below their intrinsic value. Speculative trading takes place over a much shorter period, be it a year, a few months, a few days or even less.
What are some types of speculation?
All speculators share one thing in common: they try to take advantage of price inefficiencies by buying when prices are at lows and selling when they are near highs. There are several ways to achieve this:
- Bullish speculators take long positions in the hope that prices will rise in the short term.
- Bearish speculators open short positions in the hope that prices will go down.
- Short-term traders attempt to “time the market” and typically enter and exit a position within seconds, minutes, or hours. They can use automated trading systems or place manual orders, and they set buy or sell stops to protect against market reversals.
- Swing traders typically establish positions over a longer period of time, usually between a few days and a year. Their hope is to take advantage of the “swing” of price movements.
What are some examples of speculative trading?
Speculators who can bear big risks could also be preparing for big gains. Take a look at some examples:
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The big court
Perhaps the best known speculator is hedge fund manager Michael Burry, known as “The Big Short”. He gained notoriety by shorting overvalued tech stocks in the early 2000s. He was also one of the first to call a bubble in the US housing market fueled by toxic subprime debt. When interest rates rose and mortgage holders could no longer afford their housing payments, millions of homeowners defaulted, causing a near total collapse of the US housing market and a global chain falling dominoes, since the loans were packaged and negotiated by investment banks. This crisis became known as the financial crisis of 2007-2008 and led to the Great Recession. Burry reportedly earned between $100 million and $700 million from speculation about the event.
Another example of speculative trading occurs with currencies and cryptocurrencies. Traders attempt to profit from the difference in value of one currency versus another, which can have a huge impact on prices. In 1992, George Soros, another hedge fund manager, bet that the British pound would depreciate against the US dollar, making a billion dollar profit. These days, Bitcoin speculators are known as “new day traders” since cryptocurrencies can be bought in fractions and their prices have seen huge swings.
Another example of speculation is trade opportunities related to the COVID-19 pandemic. When the Federal Reserve cut interest rates and injected billions of dollars into the markets through quantitative easing measures, they caused huge ups and downs, known as volatility. This, in particular, has led to speculation in Treasury futures.
What are the risks associated with speculation?
Buying low and selling high is much easier in theory than in practice. Therefore, speculators should beware of the many risks associated with fast money; otherwise they just bet:
- Volatility increases the level of risk in the market, as price fluctuations present more opportunities to create profits, as well as opportunities to accumulate losses. Speculators trading during periods of volatility should have a solid understanding of the VIX, or Volatility Index, as well as support and resistance levels.
- There’s an old saying in the stock market that goes, “You never know you’re in a bubble until it bursts. When prices are rising rapidly, there is potential for quick gains, but once the bubble bursts, capitulation often ensues, making it very difficult to unload its now overvalued assets.
- Short selling involves buying on margin, which can have a much greater downside than investing in cash, as losses are compounded. When something like a short squeeze occurs, the price of a stock suddenly shoots up and short sellers can lose exponentially more than their initial investment. In fact, to limit risk, the Federal Reserve has set short-selling requirements, prohibiting an investor from borrowing no more than 50% of the stock price on margin.
What are the benefits of speculation?
There are advantages to speculation; in fact, many believe that speculators help make markets more efficient. By simply placing their trades, speculators help add liquidity, and when an asset, like a stock, is liquid, it means its shares can be bought and sold quickly with minimal impact on its market price. Therefore, liquidity makes it easy to buy and sell whenever needed. Without such trading activity, markets would become illiquid.
Without speculators, there would be fewer players in the markets, which would also impact buying and selling transactions, thereby widening bid-ask spreads. The spread is the difference between the quoted price (ask) and its immediate purchase price (bid). Hence, increased trading opportunities result in easier trading activity.