The immense number of transactions between buyers and sellers every day are the pillars of financial markets. It’s the source of all their price fluctuations. Both sides may have different reasons for their activity, but most, if not all, are based on speculation. What is a speculator? How do speculators make money? How do they differ from hedgers and investors? More importantly, what roles do they play in the financial markets? These are some of the things we’ll look at in this article.
There are a few different definitions for what a speculator is. In the simplest terms, a speculator is someone who buys securities to sell them in the future at a nice profit.
You might ask, isn’t that the same thing as being an investor?
Yes, in some ways. The critical difference is that in the case of speculators, they are not interested in holding the securities for a more extended period. Unlike investors, their main reason for buying securities is to sell them instead of retaining them.
As with any other form of trading, a speculator seeks to make predictions about future price movements in a particular market, but he or she is only interested in price differentials.
In reality, there is no such thing as a 100% speculator or investor. To some extent, every investor is a speculator, and every speculator is an investor. As such, the difference between the two comes down to a matter of relative degree only.
A speculator employs well thought out strategies, typically over a shorter time frame, to gain higher profits than traditional longer-term investors. For this reason, speculators usually take on more risk, especially when it comes to anticipating future price movements. They do this to make a large enough profit to offset the risk.
You will mostly find speculators in volatile markets where price movements are frequent. They attempt to predict price changes and profit from the price moves. Speculators may even utilize leverage to boost potential returns (and losses). However, this is usually a personal choice and not necessarily a speculation strategy.
The reasons outlined above are why speculators play a crucial role in absorbing excess risk. They also pump liquidity into the market by buying and selling. Furthermore, it’s something they do, even when investors and other market players do not participate.
For instance, after the financial markets crashed following the COVID-19 pandemic, many investors stopped participating in any trades. Instead, they waited for things to calm down before going back in. Speculators, on the other hand, were having a field day with all the volatility. They made their profits (or losses) while ensuring there was enough liquidity in the markets.
How Do Speculators Make Money?
Because speculators generally take on excessive risk within a shorter period, they must be able to exert some form of ‘control’ over price momentum and direction. They do so by employing various strategies such as stop-loss orders and position sizing. Generally, their approach also includes keeping close tabs on the statistics of their trading performance.
Speculators are typically sophisticated risk-taking individuals. Despite that, they are often confused with gamblers. However, there is an important distinction. Market participants who use untested methods or execute trades based on hunches or feelings are most likely gambling. On the other hand, profitable speculation requires a lot of work with well-executed and proven strategies to make money. That is how they gain a decisive edge over the market.
To stay profitable, speculators typically look for reoccurring patterns in the market movements. They look out for commonalities as prices rise and fall within a particular period. Then they use that information to make a profit from future price movements.
Trading is detailed work, especially since prices are always moving, and there’s no shortage of variables to consider. That’s why each speculator must first develop their own tried and tested way of trading before going all the way.
How Do Speculators Impact The Market?
Let’s say a speculator believes that the price of a particular asset is going to go up. They can choose to acquire as much of the asset as possible. That, in turn, will drive up the price. Other market participants may see this activity as a positive sign. Doing so could lead to further purchases of the asset by other speculators, taking the price even higher.
If left unchecked, speculator activity can make an asset’s price go way above its actual value. The result is a speculative bubble.
We can see the same on the other side of the trade. When a speculator believes the value of an asset is about to decline soon or is currently overpriced, he or she sells as much of the asset as possible while prices are still up.
This act can cause the asset price to drop further, which other traders can see as the beginning of a downturn. If they act similarly, the price will keep on going down until the market stabilizes.
This process is how many investors essentially become speculators. Although sometimes only temporarily. The point is, they get so caught up in the wild price movements. Even though they may have initiated their position intending to hold it for the long term, they can waver once they think other people are buying or selling. That’s one way they can enter the realm of speculation, sometimes even bordering on gambling.
Types of Speculators
Speculators tend to specialize in particular markets. For instance, one speculator may specialize in commodities and only trade the commodity markets day in and day out.
Also, each speculator trades according to their style. Some are scalpers who buy and sell quickly when prices move even just a fraction of a cent. Others are day traders who look to buy and sell throughout the day. Then there are position traders who opt to hold their positions for several days, weeks, or even months before exiting.
With that in mind, there are five main categories of speculators:
As the name suggests, these are optimistic speculators. They enter the market, expecting the security price to rise, so they buy now to sell them at a profit in the future. If their expectations become a reality, they benefit from the price difference and exit the position.
This type is the counterpart of the more optimistic speculators. A bear speculator is pessimistic and expects a sharp fall in the prices of a traded security. He or she enters the trade by short selling the assets at a high price to secure profits against the expected price drop. If the value of the security falls as predicted, then they reap their gains from the price difference.
A stag speculator is generally cautious, especially compared to bulls or bears. Usually, they focus more on applying for new shares in new companies. Then, when the stocks take off, they sell them at a premium or profit.
Lame Duck Speculators
Lame ducks are a term used to describe speculators who are unable to cover their trading losses. That’s due to their inefficient trading strategies. This type also includes traders who have defaulted on a debt and are virtually bankrupt. The phrase originates from the premise that traders who are unable to fulfill their commitments and are suffering massive financial losses have to waddle away from the market.
A Jobber is a professional speculator who is also a member of the stock exchange and performs several essential functions. They are independent dealers in traded assets and typically execute the transactions in their own names. They earn profits through speculating activities and only interact with other Jobbers or the broker, never a non-member.
How Do You Speculate?
Speculative trades often involve securities with a high risk/high reward profile. Markets are always changing based on constant price fluctuations.
One of the main reasons for these fluctuations is the interplay between supply and demand. If you wanted to speculate with stocks, you could simply buy as many shares as you can when you expect the price to go up.
Because the supply of shares is limited, your aggressive buying can increase the demand for the stock, raising the price even higher.
Speculators Are Often Skilled At Fundamental Analysis
Speculators are not necessarily concerned about the business of a company but need to stay knowledgeable about its fundamentals. They excel at running detailed fundamental analyses to determine whether the security is overvalued or undervalued, which then informs their trading decisions.
A skilled speculator also knows how world events, such as the current COVID-19 pandemic and other cases of global turmoil, can influence short-term price movements in the markets. For instance, due to the lockdowns effects across the globe back in April 2020, the price of oil went below $0 as demand dried up.
Examples of Speculation
Speculative activity is present across various markets. Let’s take a look at some to give you a clearer picture:
Speculation In The Stock Market
Stocks with high-risk profiles are referred to as speculative stocks. A good example is Penny stocks. They have meager share prices and offer potentially high returns to offset the high risk associated with them. Speculation in the stock market is pretty straightforward — you buy or sell the stocks based on whether you expect the price to rise or fall and profit accordingly.
Speculation In The Currency Market (Forex)
Speculators tend to frequent the forex market because of the constant swings in the exchange rates between the traded currencies. Additionally, the market allows frequent trading thanks to the many different currency pairs that can be bought & sold within a given period.
For example, you can trade the US dollar against more than a dozen other currencies worldwide. If you expect the US dollar to soar compared to the Japanese Yen, you will buy more of it and sell for a profit.
Lastly, the leverage available in the forex market is often high. Speculators can use this to accumulate substantial profits with only a small amount of initial capital.
Speculation In The Commodity Market
Speculation can help control price volatility in the commodity markets. The reason for that is because commodities are much less widely traded compared to stocks and foreign currencies. The futures and options markets are particularly popular among speculators because those markets are predominantly speculative.
For instance, let’s say you think the price of silver will rise in the next six months. You could enter a futures contract with a silver mining company to deliver 1000 ounces of silver in six months, but you pay for it at today’s price. After six months, if the price of silver has indeed gone up, you could sell your 1000 ounces at a profit.
The best part about futures trading is that you don’t even have to take physical possession of the asset they trade before re-selling it. Commodity markets also offer high amounts of leverage, which makes speculation even more attractive.
Speculators vs Hedgers
The main difference between speculators and hedgers is their approach to risk. Speculators thrive on uncertainty and look to make as much profit as possible to offset said risk. Hedgers, on the other hand, aim to limit their risk exposure by taking an offsetting position in another security.
Advantages and Disadvantages
Like every approach to dealing in the financial markets, being a speculator comes with its unique advantages and disadvantages. These include:
1. Economic welfare – Speculators provide much-needed capital for young companies to grow and expand. At the very least, they offer price support for assets that are temporarily out of favor among other traders. Doing so helps drive the economy forward.
2. Increased market liquidity – Since speculators are actively trading, their actions pump cash to the markets where they participate. No one wants to buy or sell in an illiquid market. The characteristics of this type of market include wide spreads between bid and ask prices and the inability to make trades at a fair market price.
3. Risk bearing – Because speculators have a higher risk tolerance, they are often a good source of financing for companies.
1. Risk of unreasonable prices – Speculative activities can sometimes push prices way above or below their fair values. These price fluctuations may be in the short term only, but they can often have long-term impacts.
2. Risk of economic bubbles – This just ties to the risk of unreasonable prices. Over time, speculative bubbles can start to impact the overall economy, especially in critical industries like housing, currency, and general trade.
How to Reduce Risk as a Speculator?
As much as speculators thrive on risk, it is also essential to mitigate their exposure, so they do not use all their profits offsetting risks. This is why they must first excel at reading the market before initiating a position. They must be adequately skilled in both fundamental and technical analysis to be sure that the price of the security they are trading moves as expected.
Additionally, speculators can hedge their positions to mitigate the potential fallout of one investment. That’s what lets them avoid a complete loss with the potential profit from an offsetting asset. For instance, they can diversify their investments to limit the chances of a total loss.
Speculators are often the scapegoats for market crashes. They get accusations of driving prices to the extreme and even manipulating markets. But in reality, speculative activity is more likely to protect against market extremes than cause them. In addition to the market liquidity they provide, their active buying and selling can help prevent asset prices from swinging too wildly.
Speculation is best left to those with a high tolerance for risk and the technical know-how to navigate their chosen market. A potential speculator should also have the financial means to sustain losses in their search for profits.