Going by the dictionary meaning, ‘speculation’ can typically be explained as the forming of a theory or conjecture without firm evidence. In the stock markets, the same means to bet on the rise or fall in the stock prices or derivatives thereof on the basis of market cues or simply a conjecture.
The factor which motivates speculation is the fact that the risk of loss is somehow negated by the possibility of a humongous gain expected. A speculator has the objective of outperforming the returns achieved by a typical long-term investor on the basis of certain trends & sophisticated strategies such as Algorithmic Trading, in a much shorter period of time. These speculators typically tend to manage their losses with the help of position sizing as well as the stop-loss orders. This process undermines the underlying fundamentals of the company and gives all the weightage to the various signals which can lead to a spike in the stock prices while putting a trade for the stock. These cues could be the major macro trends & developments in the economy such as the – ensuing monetary policy review, release of Inflation data, Purchasing Managers Index (PMI) data & the expected GDP growth of the economy.
The speculation is led by the liquidity in the stock markets. So in general, more the liquidity, more would be the speculation going on in the market. This market liquidity is generally driven by the domestic as well as the foreign fund flows. Excess liquidity in the stock market may also cause a bubble, which when gets busted leads to a sharp decline in the markets as well as impacts the economy. However, the speculation is also not to be always taken negatively, as it also has some benefits such as the narrowing of the Bid-Ask spread which is on account of the liquidity. This spread is critical when it comes to hedging of risk arising due to the price movements.
There are various tools used by the traders for the purpose of speculation based punting. Some of them which are very prevalently used are futures & options on Individual stocks as well as the Indices, for e.g., S&P/ASX 200. There is a major reason why the futures and options are heavily used for speculation purposes. Prima-facie, the trading in futures does not involve the trader to put any sum of money in the markets except the initial margin money which is required to be deposited with the intermediary. Also, the trading in options only requires the trader to provide for a fraction of the price of the share called as option premium to buy an option and gains could be astounding. This is also a reason which leads to a gush of liquidity into the markets as the number of outstanding contracts are seen surging.
Coming back to the term, speculation leads to a lot of volatility in the markets which is measured & indicated with the help of S&P/ASX 200 VIX (A-VIX). This parameter provides insight into investor sentiment and expected levels of market volatility.
The other way for trading on speculation involves directly investing in stocks that appear to provide high returns. In a way, the risk and reward scenario is highly applicable for the speculative type of transactions and many penny stocks fall under this category. Hence, many investors punt on such penny stocks to make quick bucks while the risks need to be always borne in mind.
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