Financial speculation: Learn to speculate finance with amana
|What is financial speculation?|
|A brief history of financial speculation|
|The macroeconomics of financial speculation|
|Financial derivatives used for speculation|
|Types of speculation in the stock market|
Today we're looking at what financial speculation means and how it applies to trading. You may have heard of the term “speculate to accumulate” - it is a common saying amongst traders and investors. It highlights that you need to take a risk with money, sometimes, to make money.
What is financial speculation?
Financial speculation, or speculative trading (as it is also known), refers to performing a transaction that carries more risk than a standard transaction. Whether it’s a stock trade, crypto trade, or currency trade, the transaction runs a considerable risk of losing value. However, the upsides hold more value than a regular trade and may return a significant amount.
An example of this would be the recent “mini-budget” unveiled in the United Kingdom (toward the end of September 2022). The budget involved a new tax cut for the highest earners, which would be paid for by ramping up borrowing. The British Pound plunged once the UK government announced these plans. For investors, this is a cause for concern as the stability and longevity of the country’s finances could be jeopardized by such a large increase in borrowing.
The new UK Prime Minister’s economic plans about cutting taxes for big corporations and high net-worth individuals, coupled with her historical comments on borrowing, show that this budget was likely to cause shockwaves to the currency. You could have speculated that this would cause the Pound to drop and to short it off the back of this news.
Some hedge fund investors made a serious return speculating against this probability. Before the news hits, it is a weighted risk based on your information and research. Once it’s in the news, it’s as good as done. You want to get in beforehand.
A brief history of financial speculation
Financial speculation isn’t a new tool that traders use. It is one of the oldest and most effective tools if you want to make a substantial profit. It can rely heavily on others to cause momentum. Sometimes investors who quite simply don’t understand what they’re investing in but speculate based on the information in the news or word of mouth. The number of people who invested in Dogecoin from a single Elon tweet is a prime example of this.
However, in serious trading markets, speculators are extremely vital as they not only bring liquidity but also stomach the market risk. Speculation operates differently from other trading methods, such as arbitrage trading.
Arbitrage trading relies on minuscule price differences between two of the same assets, be it stock, cryptocurrency, or foreign exchange. The arbitrage trader immediately buys the asset in one market and sells it in the other. This results in profit and, if done correctly, can turn over a substantial profit.
The best example is when Sam Bankman-Fried made billions of dollars from arbitrage trading Bitcoin between Japanese and US exchanges. This type of trading is more difficult in more established markets and still requires some speculation as the liquidity needs to be available on both exchanges.
The macroeconomics of financial speculation
To dive into the specific reasons why financial speculation works, we need to assess three critical points.
● The expected price of a stock naturally displays built-in biases in one direction or another throughout a natural business cycle.
● A price correction over time plays itself out through a rise in inactive money balances in the banking system, which legendary economist John Maynard Keynes called the bear position. All this means is that as more and more people begin to think that asset prices have reached unreasonable levels, be they too high or low, they will begin to sell. This will cause the price to correct naturally and quite dramatically.
● When a price bubble begins, nothing brings the price back into a natural correction other than speculators and other investors, except for large-scale government intervention, which we saw in 2008.
This may sound like a load of waffle. To break it down for you more simply, it essentially means that financial speculation relies on word of mouth and good fortune to act as an accelerant to the initial speculators’ small campfire. This will determine whether the torch turns into a bonfire of serious profit or smokey embers of painful losses.
Cryptocurrency is a good example of this. As positive news snowballs, it will result in serious gains, but panic sellers can capitulate the whole market spectacularly. As it isn’t as well regulated as more established trading methods, this increases the volatility.
Financial derivatives used for speculation
The main categories of derivatives used for financial speculation can be broken down into four groups:
Other derivatives include CDOs (Collateralized Debt Obligations) and MBS (Mortgage Back Securities). However, these two types don’t often feature in financial speculation because the mortgage market is a fairly safe investment.
Despite how instrumental CDOs and MBS were in the 2008 financial crash, it’s harder to speculate on large markets such as this, although a handful of investors managed it in 2008. Financial speculation primarily orbits around these four types of financial derivatives.
Types of speculation in the stock market
● Market liquidity - This can be a double-edged sword when it comes to financial speculation. Speculators often provide the market with liquidity as they take on risks and with more capital than many standard investors. However, if they sell up, this could mean the cash value of the stock isn’t readily available.
● Bullish speculator - expects the prices of a particular stock or financial good to increase. Usually, a large hedge fund will release a statement to signal that now is a good time to buy, increasing market confidence and the price of an asset.
● Bearish speculator - expects the price to drop. However, they can still profit by shorting the product or selling up and holding the value in currency (liquidity) until market confidence increases.
● The welfare of the economy - If an economy is rising, such as the BRIC (Brazil, Russia, India & China) quartet in the early 2000s, this is a bullish speculation signal for financial speculation. Conversely, if the country is politically unstable or the currency loses serious value, this would result in bearish speculation.