Define Speculation

Speculation

People who buy and sell securities in the stock exchanges may have different motivations for doing so. A person may be interested in getting a good rate of return, earned on a rather consistent basis, for a relatively long period of time. For this he will choose the shares of a company which is fundamentally strong and has the potential for growth in the future.

Such a person is a genuine investor who invests his money in securities for long-term returns. There may be other persons who have a short-term perspective on their trading activities on the stock exchanges. A person may be interested in making a quick short-term profit from the fluctuations in the prices of securities in the stock market. Such a person is known as a speculator. Speculators are traders who intend to make high returns within a short span of time, making use of the short-term fluctuations in security prices.

Speculators constantly monitor the movement of share prices in the market. On the basis of their analysis of share price movements and on the basis of the evaluation of various information regarding the performance of companies, the speculative traders speculate on the future course of prices. They believe that mispricing of securities occurs periodically in the market. Sometimes, some securities may be overpriced (that is, their price may be higher than their intrinsic value) and at other times some securities may be underpriced. Speculators attempt to exploit such mispricing of securities, because it is presumed that the mispricing would be corrected by the market eventually.

Long Buy

If a speculator feels that a security is underpriced or that a security which is correctly priced at the moment is likely to show a rising trend, then he would like, to buy the security for the purpose of selling it at a higher price when the price rises as anticipated. The speculator in this case is said to take a long position with respect to that security. He is not interested in taking delivery of the security, but intends to sell it off as quickly as possible to gain some profit. Hence, he would not like to hold his long position for an extended period. He would like the mispricing to be corrected at the earliest, preferably, on the same day. Such kind of a speculative activity is known as long buy.

Short Sale

On the contrary, if a speculator estimates that a security is overpriced and its price is likely to decline shortly, he would like to sell the security at the current price and buy it sometime later when the price declines so as to deliver the security sold at the time of settlement of the trade. Ordinarily, a person sells securities which he owns. Here, the speculator is selling a security which he does not own or possess in the hope that he would be able to deliver the security on the due date ‘by buying it at a lower price within a short period of time. He hopes to gain some profit in the transaction. The speculator in this case is taking a “short position” with respect to the security by engaging in a ‘short sale’.

Fundamentally, a short sale is the sale of a security that is not owned by the seller at the time of the transaction. A short seller has to cover up his position or eliminate the deficiency by buying the security sometime in the near future. He will be able to make a profit out of the short sale transaction only if he is able to buy the security at a lower price. If the price of a security moves up against his anticipations, he will suffer a loss.

Speculation involves high amount of risk. The speculators take long or short positions on the basis of their estimation or speculation about the future movement of prices. If the prices of securities do not move in the expected directions within a short time, the speculators suffer losses.