What is Speculation in Financial Market?

"Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services." – Henry Ford.

When it comes to the share market, there are two ways in which you can take part. You can either invest in the stocks or carry out speculative trading. Among these two, speculation or speculative trading is more common and accounts for a majority of the daily trading volume in the stock exchanges worldwide.  

So, certainly, these kinds of speculation are quite common in the stock market, but these speculations cause a good amount of volatility in the stock market. Warren Buffett, Bill Gates, Elon Musk and all such businessmen who've reached new highs of success are usually great speculators.

But what exactly is speculation?

Let's get into it.

What is speculation? 

Speculation refers to the act of conducting a financial transaction that has a significant risk of losing value but also holds the prospect of a substantial gain. 

In speculation, the possibility of gain overshadows the risk of loss. A substantial profit motivates someone to get engaged in the speculation activity. 

An investor who is engaged in speculation is known as a speculator. A speculator's motive always is to get the largest amount of profit. For this, a speculator risks all or most of their capital in the expectation of profit.

Speculation is based on the expectation of a future event or on the probability of how the market will react after that event. Due to speculating, the speculators inject liquidity into the market by taking the heavy burden of risk, which is not done by normal investors. 

Speculation in the Stock Market 

In the case of the stock market, stocks associated with high risks are known as speculative stocks. They offer an immense potential of profit to compensate for the burden of elevated risk.

Trading in penny stocks with high volatility and trading in derivatives like futures and option are examples of speculation trading. Speculators trade in derivatives for short term gains and this trading has limited validity. In derivatives, speculators square off their position before the expiring date.

Speculators are important in the stock market as they supply the much-needed capital for unproven companies, which helps them expand their reach in the market. 

Speculation in the Currency Market 

Speculators tend to engage a lot in the foreign currency exchange market due to constant volatility in the exchange rate between currencies. The Forex market executes $6.6 trillion worth of transactions every day.

For instance, speculation about the exchange rate of Indian rupee with other currencies around the globe is quite common. The most commonly traded currency pairs are EUR/USD, USD/JPY, GBP/USD and USD/CHF.

Forex market is dominated by hedge funds and asset managers with a million-dollar capital. The leverage is remarkably high in the forex market, which makes it attractive for speculators with limited capital to generate profit.

Speculation in the Commodity Market 

Speculation is necessary for the commodity market as, without the speculation, the commodity market will be left with an extremely limited number of traders. 

Speculators help against the volatility in the prices of commodities. They make a future contract to encourage traders to stockpile to avoid shortages.

Speculators add a great amount of capital into the commodity market, which eases trading among all the market participants. The commodity market supplies excessive amounts of leverage, which is also one of the reasons why commodity trading is popular among speculators.

Speculators increase the market participants in the commodity market, thereby preventing market manipulation.

Example of speculation 

Let’s say the stock of XYZ ltd is trading at Rs. 1,500. You expect that the price of the stock would move to around Rs. 2,000 in three months. But, since it is impossible to predict the movement of stock, you’re not 100% sure if it would move upwards. 
In this situation, you decide to enter into the futures contract of XYZ Ltd. to carry out a speculative trading transaction. So, you purchase a futures contract of XYZ Ltd. at a strike price of Rs. 2,000 with an expiry date of three months. Your intention is just to profit off the short-term price movements of the stocks. Around two months later, you find that the price has risen up to around Rs. 1,900, 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. So, this transaction that you executed is called Speculation. 

Investing vs speculation 

Positive Effects of Speculation in the Market

• Speculators add liquidity to the financial market. They keep the market fluid and simplify easy trading between buyers and sellers. 
• Speculators supply capital to young or small companies, which helps them to grow and expand in the market. 
• Speculators help to finance the companies which have a poor rating or which have some financial troubles, thereby helping them to sustain. The only other option for these companies to raise funds, other than speculators, is borrowing money, i.e., take loans.

Disadvantages of Speculation 

• The major disadvantage of speculation is an economic bubble which can be created due to an unrealistic rise in price. Due to the price rise, more and more investors start buying that rallying stock. However, this bubble bursts eventually, and prices decrease instantly, which causes chaos in the market. The Housing market bubble of the US market in 2008, is a well-known example of an economic bubble.
• Speculation can sometimes lead to unreasonable prices. Sometimes the prices will be too high, and sometimes they will be too low, but it does not reflect the true value of the company. Though they may stay for a fleeting period, but sometimes, their aftereffects last for a prolonged period. 
• Sometimes people buy assets or securities in the anticipation that prices will increase soon, which leads to an increase in demand for that assets or securities. However, sometimes the speculators are not sure when the prices will change. If the price changes do not happen according to the expectations of the speculators, they usually sell those stocks to avoid further loss. Common investors who have invested along with speculators get trapped in this process. 

Closing Remarks 

Speculations are significant in the market. Market regulators try to control speculation, but they are not able to do so significantly. If humans are involved in trading, speculation will happen due to human psychology. 

A prudent investor should know about the effects of speculation. They should find speculators in a particular stock and use that speculation for personal benefits, keeping in minds the risks associated.