Speculation is a concept in economics and an actual investment practice that involves the trading, specifically the purchase or selling, of a particular asset based on an assumption that it will become more valuable in the future. It is essentially about investing in expectation of earning profits from market fluctuations and market inefficiencies.
Defining speculation: A simplified explanation
Nonetheless, true to its name, speculation is about positive assumptions about the future or exploiting probabilities. Although there is a fine line between gambling and investing, experienced speculators minimize such informed decisions based on historical data, current market trends, and relevant market outlooks.
To explain further the meaning of speculation, note that a speculator would purchase an asset based on an assumption that its price would go up sometime in the future. Hence. Once the price of this asset goes up or if demand goes up resulting in price increase, he or she will resell this asset, thus earning a profit. Speculators are essentially forward thinkers and speculation is about betting on future prices.
Assets that are commonly subjected under speculation include commodities such as oil and gas, and farm produces such as corn and wheat; raw materials such as steel and wood; real estate and currencies; as well as financial instruments such as stocks or securities and bonds.
The assets that are commonly speculated belong in markets in which price movements are frequent and volatile due to known factors, including the relationship between demand and price. Remember that speculation banks on market fluctuations and market inefficiencies. However, this practice has advantages and disadvantages.
Terminologies: Related concepts and practices
Below are the common terminologies or concepts and practices that are often used alongside the practice of speculating in the markets:
1. Derivative Securities: A derivative is a financial security that has a value coming from an underlying asset or assets. It is essentially a contract between two or more parties. In the realms of speculation, speculators do not actually own the underlying asset but instead, own the right to buy or sell such. A notable example of a derivative security that is commonly subjected to speculations is stock options.
2. Futures Market and Futures Contract: A futures market is an auction market in which assets are negotiated traded for delivery on a specified date in the future. Central to this trading is the use of a standardized type of a forward contract called futures contract. This contract is a legal agreement to buy or sell a particular asset at a predetermined price on a specified future date. Hence, an asset might be bought or sold in the futures market even if it is still physically inexistent. Some speculative practices involve the use of futures contract. Examples are the trading of agricultural products, oil and gas, and raw materials.
3. Hedge and Hedging: A hedge is an advantageous investment position made to counterbalance possible losses and gains coming from a particular investment decision. Thus, hedging is a risk management practice used to reduce if not eliminate the undesirable outcomes of an investment. Speculations can give individuals or organizations a hedge, especially if they purchase assets in advance to secure their current and future stockpile, thus managing the risks associated with price and supply fluctuations. Those who sell assets in advance can hedge risks associated with price and demand fluctuations.
4. Price Movements and Technical Analysis: A change in the price of an asset over a short or predefined period is called price movements. The methodology for forecasting price movements is called financial technical analysis it involves studying historical market data, business cycles, stock market performance, and/or market trends, among others. Most speculators focus solely on price movements instead on the financial intrinsic value or in other words, the actual economic value of a particular asset as determined not only by its price but also of other tangible and intangible factors such as utility and relevance.