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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.
Key Takeaways
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Speculation is an activity wherein you buy or sell an asset with the expectation of profiting from short-term price movements.
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Individuals involved in speculative trading focus primarily on the price movements of an asset rather than its fundamentals such as the inherent value of an asset.
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Day trading, short selling, swing trading, margin trading, etc., are a few types of speculation strategies.
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Speculative trading can be executed successfully only if you follow a solid risk management plan.
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.
Also read Investing vs Speculating: What is the Difference? here
Types of Speculation Strategies
There are different types of strategies, a few of which have been briefly discussed below.
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Swing Trading: This implies holding positions for a timeline varying between days and weeks. The main agenda behind this is to capitalise on the market trends.
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Day Trading: This strategy involves buying and selling assets on the same day so that you get the benefit from short-term price changes.
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Scalping: This is an ultra-short-term strategy wherein you make numerous trades on a daily basis to capture small profits from minor price fluctuations.
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Short-selling: Different types of speculators enjoy the benefit from decline in asset prices through selling, borrowing and buying shares again at much lower rates in this strategy.
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Options & Futures trading: This is a strategy in which options and futures are used to bet on future prices of assets.
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Margin trading: Money is borrowed from brokers to increase trading size which helps scale up potentia losses or profits.
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Arbitrage: This involves tapping the differences in prices of the same asset in different markets and earning profits.
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Pattern trading: In this strategy, different types of speculators use historical price data and various other patterns to predict the future movement in market.
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 ₹2,000. You expect that the price of the stock would move to around ₹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 utilise 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 ₹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 ₹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.
Reward and Risk in Speculation
You can experience both speculative risk and reward when you opt for this strategy. While there is always a risk for significant losses, you get to enjoy substantial gains over a short period. Higher potential returns are often linked to an increased likelihood of losses. Here are the rewards you can enjoy in speculation.
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High possibility of earning substantial profits within a short timeline.
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Speculators help in efficient price discovery as they trade actively based on market expectations, enabling asset prices to reflect realtime information.
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Speculators increase the trading volume, enhancing market liquidity and making it easier for other investors to buy assets.
The risks are evident in speculative trading because of these main reasons:
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Price uncertainty and high volatility can result in sudden, significant losses.
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There is a chance of losing even the entire capital invested, especially when advocating strategies like leverage or margin trading, where gains and losses are amplified.
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Since speculative investments focus solely on price movements or market sentiment, the fundamental value of the asset is neglected.
How to Manage Risk in Speculation
It is easy to manage speculative risk if you have a solid risk management plan and follow a systematic approach. Diversification is one of the effective ways which help you spread your capital across different assets, sectors or markets. This helps you avoid a single adverse event in one area.
Apart from this, you can also focus on position sizing. In this approach, you should not risk more than a small percentage of your total trading capital on any single trade. Some other options include maintaining a favourable risk-reward ratio, implementing stop-loss orders and managing leverage wisely.
Famous Speculators and Their Approaches
Here is a list of some of the famous people involved in speculative trading and their approaches.
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George Soros is known for his macro trading based on the theory of market reflexivity.
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Jesse Livermore focused on market trend awareness, learning from losses.
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Rakesh Jhunjhunwala combined skill trading with a long-term value investing philosophy.
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Warren Buffet is a value investor focused on buying undervalued companies with strong fundamentals.
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Ed Seykota, being a trend follower, focused on using a mechanical and systematic approach based on signals to identify market trends.
Conclusion
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.
While there is always the threat of speculative risk, the rewards are equally satisfying. You can earn substantial profits in a short period, helping you build a significant sum over time. Various types of speculators like Warren Buffet, Rakesh Jhunjhunwala, George Soros, etc., have been successful with their discipline and systematic approach.