A speculator is an active trader who perceives a change in the price of financial instruments in either direction and tries to profit from it. They can trade instruments with a perceived increase or decrease in the price. Contrary to investors, speculators are focused on short-term fluctuations in prices that can be driven by events.
Speculators take considerably higher risks than investors. They execute several trades with smaller profits in short periods and can adopt several types of trading strategies. Speculators are usually categorized based on their trading style and strategy or by the entity that they are conducting trades for.
Understanding what is a speculator
A speculator is an individual or an entity that trades with the hope of gain but with a risk of loss. The process is called speculation in trading. Speculators try to predict price movements of securities in either direction. They might also be involved in the old adage of buying low and selling high. Since speculators also profit from downward move in the price of securities, they also engage in short-selling. Borrowing high and selling, to then buy low. A speculator’s investment horizon tends to be shorter than investors. They require volatility to be able to profit from their trades. Therefore they bet on sudden price movements.
How does speculation work?
Unlike a common notion, speculation involves planning and hard work. It doesn’t work randomly placing orders and betting against the market.
The most significant reason behind the existence of speculators is that they are opponents of the efficient market hypothesis. They believe markets tend to over or under-react to certain events. That in turn means certain financial securities are under or overpriced. As markets adjust to these inefficiencies, volatility increases. Speculators rely on volatility, which causes sudden price fluctuations to be able to profit from their shorter-term trades.
Do speculators use fundamental or technical analysis?
There is no definite answer to this. Different speculative strategies entail the use of either one or both. Although speculators are often associated with extensive use of technical analysis, most of them also conduct deep fundamental analysis.
They research the markets and certain financial securities they believe would adjust due to inefficiencies in the market. At some stage, the market realizes the potential gap and ratifies it. Speculation is profiteering from such circumstances.
An important aspect of speculation is a risk. Speculators take significantly higher risks than investors. This is due to the fact that their trades are often trying to profit from short-term price movements, which may not materialize. Price inefficiencies are very common among highly volatile financial instruments. Therefore speculators will often look for those types of securities to trade. The higher volatility implies that the price fluctuations may be more sudden, which increases their expected returns from each trade. However due to the high volatility of such instruments, the risk speculators bear tends to be much higher than investors.
Types of Speculators
Traders can speculate in several ways. Their trading strategies define their role. Also, we can categorize speculators based on their entity structure.
Types by Role
There are four broad categories of speculators by role or by trading style.
These speculators anticipate a rise in the price of the underlying financial security. They purchase low and sell high in a short period.
Bulls follow the buy-and-hold strategy often resembling investors but their trading span is much shorter.
Bears are the opposites of bulls. They anticipate a fall in the prices of assets or financial securities. They often follow the short-selling strategy.
Short-selling is trading on buying securities on borrowed money and then selling it quickly when prices move favorably.
Stags are day traders that cash on the price movements in either direction quickly. They require liquid capital investment to execute this strategy.
Stags often rely on executing several trades in a single trading day with small profit margins.
Types by Entity
There are several types of speculators by entity type as well.
- Individuals: These are individual traders who execute their trading through online brokers or other electronic trading mediums, similar to retail investors.
- Hedge Funds: These are managed investment portfolios that are run and managed by a portfolio manager. They aim to maximize portfolio returns through a combination of investments, speculation. They are characterized by hedging their potential risks.
- Market Makers: These are trading firms that contractually execute trades for investors and trades. They do so by offering bids and offers. They aim to provide market liquidity and benefit through lower trading costs in return.
- Funds: These firms such as mutual funds, ETFs, or other investment firms may be engaged in speculative behavior. Depending on the fund’s strategy they may try to maximize the returns for their clients, using a trading strategy that involves speculation.
Impact of speculators on the market
Speculators receive a bad reputation generally. However, they offer some benefits to the market as well.
Speculators often rely on smaller profits and a number of trades executed in a short time. It means they execute more trades on average as compared to investors. Their higher trading frequency means higher liquidity in the market. Although speculators may not own any underlying asset directly, they bring valuable trading volume through speculation.
Help Market Efficiency
Speculators help create balance in the market in several ways. They tend to buy securities for perceived demand that further escalates the trend. Conversely, they also sell off securities with a perceived excessive supply in the near future. Overall they help the market being as efficient as possible, by taking multiple sides of different trades.
Speculators take more trading risks than investors. In several ways, they provide financing to growing companies and assets that would otherwise be hard to obtain. Without speculators taking risks, the market would be entirely different.
Reduced bid-ask spread
Speculators also help to narrow the bid-ask spread of different financial instruments. Their ability to place different trades increases liquidity and directly narrows down bid-ask spreads.
Reduced market volatility
Although trades and speculators rely on volatility to turn a profit, their trades actually reduce the volatility in the market. If there were no speculators some securities would be extremely volatile. Speculation ensures that the volume traded on a particular security increases, which in turn decreases its overall volatility.
Image source: Insider