Speculation

Key Takeaways

• Speculation in the context of financial markets refers to traders transacting with the intent of making a profit on price movements, before they occur.

• Speculators can often provide market liquidity and reduce the bid-ask spread, thus enabling the producers to hedge risk of prices efficiently

What is Speculation?

Speculation in the context of financial markets refers to traders transacting with the intent of making a profit on price movements before they occur. Investors purchasing a speculative investment often focuses on the price fluctuations to make money. If there is not a chance of significant gain, Speculators would lack the motivation to speculate as it carries substantial risk. Speculation in the markets is not necessarily bad as it provides liquidity to hedgers and absorbs excess risk by selling and buying when other investors do not invest.

How does speculation work?

Speculators can often provide market liquidity and reduce the bid-ask spread, thus enabling the producers to hedge the risk of prices efficiently. Speculative short-selling can also help in keeping check on the rampant bullishness and preventing the formation of an asset price bubble. Hedge funds and mutual funds often get involved in speculation in the forex markets as well as stock and bond markets.

Difference between speculating and investing

Anytime someone invests money in an enterprise hoping to make a profit, that person is investing. In this case, the investor thinks that it has a good chance of success as he does a thorough investigation.
What happens, if the same person invests money in a project that has a significant chance of failing? They are speculating in this instance. Chance or uncontrollable (external) forces or circumstances play a major role in whether something succeeds or fails.