The ChoosaBroker Trading Academy
“Greed is good.” Thus spoke Gordon Gekko in Oliver Stone’s cynical 1987 movie “Wall Street.” Speculators are often equated with that iconic corporate raider. Their public image is that of manipulators. But speculation is neither immoral nor illegal. On the contrary, speculators play a key role in making free markets more efficient. In this lesson, we will learn about:
Who Are Speculators?
A speculator can be broadly defined as someone who trades financial assets like stocks, derivatives, currencies and commodities with a higher-than-average risk in anticipation of earning and a higher-than-average profit. Speculators generally pay little attention to the fundamental value of an instrument and instead focus primarily on price movements in an attempt to profit from short-term variations in the market value of a tradable financial asset.
If a speculator believes that a particular asset is oversold and is likely to increase in value, he or she may decide to purchase as much of it as possible. If the speculator’s point of view is shared by a majority of the other market participants, it could lead to further buying in the asset, which in turn would boost its price and result in a profit for the speculator.
The reverse can be seen during market downturns. If a speculator deems an asset to be overbought and ripe for a price drop, he or she may choose to “short sell” as much of the asset as possible. If other market participants follow suit, supply of the asset would gradually outstrip demand, pushing prices lower and yielding a profit for the speculator.
Different Types of Speculators
Financial market speculators can be classified in to four distinct groups:
- Bull – A Bull is an optimistic speculator, who buys an asset in expectation that its market value would increase in the immediate future. For example, a speculator may purchase shares of a company, whose quarterly earnings are scheduled to be released the following day, forecasting that its earnings and revenue would beat analysts’ expectations.
- Stag – A stag is a cautious speculator. Such a person applies for a large number of shares in a new issue in anticipation that the demand for the new shares would overshoot the quantity being issued. This is turn would lead to an increase in the share’s price when it is first transacted on the stock market. Stags seek quick profits and their holding periods can typically range from a few hours to a few days.
- Lame Duck – When speculators are unable to meet their market commitments, they are said to be struggling like lame ducks. The term was first used in the London Stock Market during the 1700s to describe someone who had defaulted on his or her debts. Any speculator, who due to his ineptitude, has suffered a string of big loss-making trades and has either entered bankruptcy or is nearing it, is said to have turned in to a lame duck.
– The Good, The Bad, The Ugly
The role of speculators in financial markets has been the cause of a great deal of conjecture among both regulators and policy makers. There exists a large bloc of academics, who deride the very act of speculation, attributing it as the root cause of pretty much every financial crisis since the Dutch tulip mania of the 1630s. Let us look at some of their reservations.
The blame for most economic bubbles has been laid at the doors of speculators. An asset bubble is said to have formed when the price exceeds an asset’s intrinsic value by a considerable margin. Because it is difficult to derive intrinsic values in live markets, asset bubbles are often identified in retrospect. However, the cause of bubbles remains disputed, with new research suggesting that bubbles may appear without speculation and uncertainty. Some economists have even linked price movements within a bubble to economic fundamentals such as cash flows and discount rates.
Crowd behaviour, propped by bouts of increased speculator activity, tends to lift market volatility at certain times. As volatility in a market rises, it means that an asset’s value can potentially be spread over a wider range of values. Most spikes in oil prices or rapid fluctuations in a currency’s value are examples when volatility is heightened due to influx of a greater than usual number of speculators.
Should Financial Speculation Be Banned?
The economic disadvantages that have been assigned to speculation have resulted in numerous attempts over the years to put in place regulations to try to limit the impact of speculators. Most of these regulations have been enacted in response to an economic crisis as was the case with the Bubble Act of 1720, which the British parliament passed in the wake of the South Sea Bubble. Another notable example was the Glass-Steagall Act, which was adopted in 1933 following the Great Depression in the United States. In the aftermath of the 2008 financial crisis, the Dodd-Frank Act empowered the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission to propose regulations with a view to restricting speculative activity in futures markets by initiating position limits.
Notwithstanding the Dodd-Frank Act, speculation has been, and will always be with us, whether in financial markets or otherwise. In a perfect world, where producers could directly sell to consumers, there would be no need for speculators. However, the world we live in is far from perfect. Speculators add the much-needed liquidity to markets and so long as they remain within the framework of regulations, can add value to an economy. Let us examine a few of these benefits:
- Sustainable Consumption Level – Speculators play a key role in highlighting any demand-supply mismatches and stabilizing market prices. Suppose, during a particular year, the agricultural harvest in an economy is too small to fulfil consumption at its normal pace. Speculators jump in, expecting to profit from the supply scarcity. Their purchases lift prices, denting consumption demand so that the smaller supply would last for a longer duration. Producers, on their part, are encouraged by the higher than usual prices and try to capitalize by growing more or importing, both of which help reduce the shortfall. Contrarily, when prices are higher than warranted, speculators sell, pushing prices lower, and encouraging greater consumption and exports, which ultimately help to deplete the surplus.
- Risk Bearers – Speculators are typically willing to take greater risk than the average investor. They often bet on assets, securities or companies that are unproven or are trading at very low prices, and which conservative investors generally tend to shy away from. Speculators frequently provide the capital that enables upstart companies to grow, or extend price support to assets that have fallen out of market’s favour.
- Benefits of Shorting – Short-selling as a market strategy is employed pre-dominantly by speculators. Shorting an asset has shown to slow the pace of formation of asset bubbles by alerting the wider market of any unsustainable practices. In the absence of speculators, the efficacy of this warning mechanism would be lost.
- Guard Against Manipulation – While many people acknowledge speculators’ importance in arresting economic shortages and smoothing out market prices, very few recognize their role in curbing manipulation. In markets with strong participation from speculators, it becomes extremely difficult to pull off large-scale manipulations. Yasuo Hamanaka, otherwise known as “Mr. Copper” is a glaring example of this phenomenon. A trader at Japan’s Sumitomo Corp, Hamanaka carried out innumerable unauthorized bets in secret accounts between 1985 and 1996, but had to eventually suffer losses to the tune of $2.50 billion after more and more speculators executed opposing trades.
Final Few Thoughts
Taken cumulatively, the economic benefits of speculation outweigh the drawbacks. Speculators help generate liquidity in financial markets and try to move risk to those who can handle it. Despite the constant badgering by financial press, the potential for outsized profits will keep attracting people. Speculators are an important cog in the economic wheel. One of the greatest speculation in recent years is around Cryptocurrencies, which is seeing a bit of a come back in recent times. Selecting the best online broker is the key intermediary between the speculator and the markets, if you are specifically interested in Crypto, have a look at the best Cryptocurrency brokers 2020.