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What Is Speculation?
Ready to roll the dice in the stock market? In finance, big risk taking is known as speculation. Traders who speculate invest in assets that have the potential for big gains—as well as big losses. Speculative traders and investors, or speculators, purchase an asset in the hopes that its value will increase in the near term. Conversely, they could also invest in the hopes that an asset will lose value, which is a practice known as short selling.
Speculators believe the greater the risk, the greater the reward.
Unlike fundamental analysis, speculators tend to solely focus on price movement. In the stock market, they pay little attention to earnings reports, analyst estimates, or other company history. Instead, their goal is to make a quick profit by getting in and out of a stock, which has inspired the term “fast 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 makes long-term investments in companies usually trading below their intrinsic value. Speculative trading occurs over a much shorter timeframe, be that a year, a couple of months, a few days—or even less.
What Are Some Types of Speculation?
All speculators share one thing in common: They are trying to take advantage of price inefficiencies by buying when prices are at a bottom and selling when they are near a peak. There are a few different ways to achieve this:
- Bullish speculators enter long positions with the expectation that prices will rise in the near term.
- Bearish speculators open short positions in the hopes that prices will fall.
- Short-term traders attempt to “time the market” and are usually in and out of a position in a matter of seconds, minutes, or hours. They could use automated trading systems or place manual orders, and they set buy stops or sell stops to protect themselves from market reversals.
- Swing traders usually establish positions for a longer timeframe, usually anywhere between a few days and one year. Their hope is to profit from the “swing” in price movements.
What Are Some Examples of Speculative Trading?
Speculators who can stomach big risks could also be setting themselves up for big gains. Take a look at a few examples:
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The Big Short
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 U.S. housing market, which was fueled by toxic subprime debt. When interest rates rose and mortgage holders could no longer afford to make their housing payments, millions of homeowners defaulted, causing a near-total collapse of the U.S. real estate market and a global chain of falling dominoes, since the loans were packaged and traded by investment banks. This crisis became known as the Financial Crisis of 2007-2008 and led to the Great Recession. Burry is said to have made between $100 million and $700 million from speculation on the event.
Another example of speculative trading occurs with currencies and cryptocurrencies. Traders attempt to profit from the difference in value of one currency with respect to another currency, which can have a dramatic impact on prices. In 1992, George Soros, another hedge fund manager, bet that the British pound would depreciate against the U.S. dollar, netting a billion-dollar profit in the process. Nowadays, Bitcoin speculators have become known as the “new day traders” since cryptocurrencies can be bought in fractional pieces, and their prices have witnessed enormous swings.
Trading opportunities related to the COVID-19 pandemic are yet another example of speculation. When the Federal Reserve slashed interest rates and also injected billions of dollars into the markets through quantitative easing measures, they caused enormous ups and downs, known as volatility. This, in particular, led to speculation of Treasury futures.
What Are Some Risks Associated With Speculation?
Buying at the bottom and selling at the top is much easier in theory than in practice. Therefore, speculators must beware of the numerous risks that come with fast money; otherwise they’re just taking gambles:
- Volatility increases the amount of risk in the market, because price fluctuations present more opportunities to create profits—as well as opportunities to mount losses. Speculators who trade 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 rise rapidly, there is the potential for quick gains, but once the bubble pops, capitulation often follows, which makes it very difficult to offload one’s now-overvalued assets.
- Short selling involves buying on margin, which can have a much steeper downside than investing in cash, because one’s losses are compounded. When a phenomenon like a short squeeze happens, a stock’s price suddenly skyrockets, and short sellers can lose exponentially more than their initial investment. In fact, as a way to limit risk, the Federal Reserve has set requirements for short selling, prohibiting an investor from borrowing no more than 50 percent of the price of the shares on margin.
What Are the Benefits of Speculation?
There are upsides to speculation; in fact, many believe that speculators help to make the markets more efficient. Simply by placing their trades, speculators help to add liquidity, and when an asset, such as a stock, is liquid, that means its shares can be bought—and sold—quickly with minimal impact to its market price. Therefore, liquidity makes it easier to buy and sell whenever it’s necessary. Without such trading activity, the markets would become illiquid.
Without speculators, there would be fewer players in the markets, which would also have an impact on buy-and-sell transactions, thereby widening bid-ask spreads. The spread is the difference between the quoted price (ask) and its immediate purchase price (bid). Therefore, increased opportunities for trading result in easier trading activity.