When it comes to the stock market, there are two primary ways in which you can take part. You can either invest in the stocks or carry out speculative trading. The logic behind these two concepts are drastically different from each other. Among these two, speculation or speculative trading is more popular and accounts for a large majority of the daily trading volume in the stock exchanges in India and the world. Let’s take an in-depth look at this unique concept and see how speculation in trading impacts you as an investor.
What is speculation?
In financial parlance, speculation refers to an activity where you buy or sell an asset with a predetermined notion or hope with respect to its future price movement. For instance, let’s say that you buy a box of mangoes today anticipating a rise in the price of the fruit a few days down the line. This kind of an activity is what is termed in the finance world as speculation.
What is speculative trading?
Many stock market participants also employ the concept of speculation in trading. With respect to the stock market, any high-risk trades that you undertake in the hopes of earning a huge profit from such a trade is known as speculative trading.
Speculative trading is so risky that the chances of you losing a significant chunk of your investment capital is very high in the event where the trade doesn’t go according to your expectations. On the other hand, the chances of you earning major returns are also high. So basically, such trading activity is more of a high-risk and high-return proposition.
Generally, most individuals involved in speculative trading are most concerned with only the price movements of an asset rather than its fundamentals such as inherent value or dividends. This is because such trading activities only look for short-term gains and not long-term wealth creation.
Trading in the derivative segment such as futures and options is one example of speculative trading since it involves purchasing or selling them in anticipation of a future price movement. Also, these instruments have only a limited validity and are designed to offer short-term gains to the trader. Individuals involved in the speculative trading of derivative contracts of an asset tend to square off their positions before their expiry date.
Speculative trading – an example
Let’s take up an example to better understand the concept of speculation in trading. We’ll stick with the derivatives segment, more specifically, the futures segment.
Assume that the stock of Reliance Industries is currently trading at Rs. 2,000. You expect that the price of the stock would move to around Rs. 2,500 in a matter of three months. But, since it is impossible to predict the movement of stock prices, you’re not really sure if it would make the move up.
In such a situation, you decide to utilize the futures contract of Reliance Industries to carry out a speculative trading transaction. And so, you purchase a futures contract of Reliance Industries at a strike price of Rs. 2,500 with an expiry date that’s three months from now. However, the intention of your purchase is not to hold the contract till expiry to take delivery of the shares. Your intention is to profit off the short-term price movements of the stocks.
Around two months later, you find that the stock price has risen up to around Rs. 2,400, just as you predicted. Now, since your motive is to only profit off the short-term price movements, you decide to square off your position by selling the futures contract for a nice lump-sum profit without waiting till the expiry.
This transaction that you conducted is what finance and stock market experts call speculation in trading.
Speculation in trading exists not only in the stock market, but also in other financial markets too. Currencies and commodities are two of the other markets where speculative trading is rife. Here’s a word of caution. Although speculative trading might seem like a highly lucrative option to generate profits, it is extremely risky. This activity is best suited for risk aggressive individuals with a large tolerance level, because of the possibility of losing huge portions of the investment if the market doesn’t move according to expectations.