A beginner's guide: What is speculative trading?

Education / 5 Min Read
Milan Cutkovic / 10 Aug 2021

The world of finance is a complex, nuanced and sometimes daunting place. There are many different types of traders with differing motivations and strategies for success. One of the more common types of trader, by far, is the speculative trader.

In this article, we dive into exactly what is speculative trading and how it differs from investing. We also provide some tips for new speculators who may be interested in trying this type of investment strategy out for themselves and detail the many advantages and disadvantages that come with speculation trading.

What is speculative trading?

Speculative trading is a form of trading where traders look to profit from market price movements - whether the market goes up or down. It stands in contrast to traditional investing, which looks deeply at the fundamental values of an investment.

Contrary to popular belief, speculative trading is not necessarily as extremely risky and high in return as many would think. Nor does it always refer to trades that have the potential for significant gain.

Instead, speculative trading revolves primarily around, you got it - speculation. The art of speculation is not fixed in a single direction (eg. versus investing which primarily looks for the investment to increase in value). This means that speculation can allow us to buy an asset (if we expect its price to increase) or sell an asset (if we expect its price to decrease).

In terms of the risk involved in speculative trading - it can be as well managed as any traditional investment out there. There is your bias (up/down direction) followed by the levels which you would close out a profit (or a loss). So in many senses, it is not that different compared to traditional investing and in fact, the ability to play both directions (up/down) gives you a slight edge over investors who only look for investments that will rise.

We can see examples of speculative trades in black swan events. So what exactly are black swan events? They are events that are extremely rare and difficult to predict with a huge economic impact that follows after. An example of such an event would be the 2008 global financial crisis.

What is an example of a speculative investment?

Let's stick with the same example: the 2008 global financial crisis.

So what happened in 2008? The global financial crisis was caused by the housing market bubble that began to form in 2007. Lower interest rates reduced the cost of borrowing for businesses and consumers. The result was an increase in home prices as homeowners took advantage of the low interest rates to take out loans they could not afford. These loans were then repackaged and sold as low-risk financial instruments, developing a secondary market for these subprime loans.

Eventually, interest rates rose and home ownership reached a saturation point. Home prices tumbled, triggering defaults and sending out huge ripples that collapsed the global economy in 2008.

So how is this related to speculative trading? While most investors were optimistic about the economy, Michael Burry, a hedge fund manager was one of the first investors to speculate and profit from this subprime mortgage crisis, as he recognised and predicted the collapse of the housing market bubble.

He shorted the market by persuading investment banks to sell him credit default swaps (which will compensate him in an event of a default) against subprime deals he saw as vulnerable. As a result of this speculation, he earned a personal profit of $100 million.

Types of speculative traders

A speculative trader tries to make a profit from changes in the prices of a particular financial instrument. We can divide speculators by their directional view, their trading style and what category of the market participants they are in.


Directional view:
A bullish speculator anticipates that the price of a certain financial instrument will increase over time. They would therefore enter a long position.

For example, a trader who expects that the Dollar will appreciate against the Swiss Franc over a specific period of time would go long USD/CHF.

A bearish speculator is betting that the price of a certain financial instrument will fall over time. They would therefore open a short position.

For example, a trader anticipating a decline of the Euro against the Australian Dolllar would go short EUR/AUD. Find out more about what is the difference between bull and bear markets.

Trading style:
Short-term traders usually try to profit for market movements that occur within a short period of time - which could be anything from a couple of seconds, minutes or hours. This type of trader could be using an automated system or execute his trade manually.

Swing traders hold their positions over a longer period of time - this could be anything from a couple of days up to a year or longer.

Type of market participants:
There are a variety of market participants who are looking to speculate - banks, hedge funds, proprietary trading firms, market makers, commodity trading companies, individual traders.

Investing vs speculation

It's important for all traders to make smart decisions with their money and first understand the difference between investing and speculating. 

What is the difference between investing and speculating?

The main difference between investing and speculating is the amount of risk a trader is willing to take. Investors are usually happy to take a low-medium level of risk in order to earn a satisfactory return on their initial capital. 

Speculative traders are more likely to take a higher level of risk to be rewarded with higher returns from their bets, which can go one way or the other. 

Investors are more likely to buy and sell ETFs, stocks and stock CFDs, mutual funds, and a range of other financial assets to generate their profit or income. While speculative traders are open to putting their money into instruments with a higher probability of failure, and could include CFD and options.

How do you speculate

There are many different ways to speculate in trading. They can be due to fundamental reasons such as our example above on the subprime crisis. More often than not, though, it is due to technical reasons (using technical analysis).

In the world of trading, there is a tremendously popular technique called “technical analysis” which uses different types of analysis on the charts (primarily) to determine the direction of where the market is heading. Little to no analysis is done on the fundamentals of a company before taking such trades off technical analysis. Understand some of the key technical indicators used in technical analysis to speculate using live charts.

Speculative trading also tends to be more short-term in nature - hence the reason why analysing years worth of financial data of an asset is not going to be very useful for it. Traders tend to have a short term bias - believing that the market is either going to head up/down over a short period of time and then take a trade on it.

What are the risks of speculation?

It is also important to understand the risks involved in speculation. Speculative risk is a category of risk that, when undertaken, results in an uncertain degree of positive gain or negative loss of capital value on a particular investment. All speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances. What this means is the risk that an investor takes on when taking speculative risk is a known risk as opposed to an unknown risk.

An example of this would be the risk of a natural disaster happening, this would not be speculative risk necessarily if it occurs as the investor would not have consciously considered the probability of a natural disaster occurring when making the speculative investment or trade.

On the other hand, if the asset value drops by 0.5% when an investor makes a trade that they expected the value to increase on, this is considered a speculative risk as the trader knew and is consciously aware that the market for the asset will fluctuate, and thus he can never accurately predict the asset value with extreme precision. In short, a known risk is a speculative risk but unknown risks are not speculative risks.

When it comes to trading, risk shouldn’t always be looked upon too favourably. The purpose of trading is to maximise rewards, not to take dangerous risks. Therefore, by those standards, even speculative risk is dangerous when it comes to trading.

The trader should be looking to maximise their returns while minimising all their risk categories, including speculative risk. As it takes a risk to make rewards in the world of financial trading it should be the goal of any good trader to manage their risk profile to make rewards.

Advantages of speculative trading

Speculative trading allows you to profit from price movements in either direction. It also gives you the option to hedge your risks when holding a long-term investment.

For example, you may own stocks of a company which you expect to outperform over the next 10 years. However, there might be certain factors or a multitude of market events that may cause an abrupt fall of the stock price in the short-term.  Instead of selling the physical shares, a trader might take a short position through a CFD contract to profit on this short-term price movement without adjusting his portfolio unnecessarily. 

Speculators are also important contributors to the stability of financial markets. Markets - whether it is the stock market or commodity markets - would be significantly less liquid if there were no speculators present. This would lead to an illiquid market with high transaction costs.

Disadvantages of speculative trading

Individuals engaging in speculative trading must be aware of the risks that come with it. It is far more demanding than traditional investing, as traders must be able to operate under pressure and make decisions within a short period of time. Overtrading or underestimating the risks can occur far more often than in traditional investing.

 

 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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