Speculation is when a person or firm takes a long (ownership) or short (sell something without previous ownership) position in an investment. The person or firm is then called a speculator. The long speculator benefits when the price of the investment increases, whereas the short speculator gains when the price of the investment decreases. Both long and short positions are following the buy-low sell-high strategy except that the short speculator is reversing the time sequence of trades selling high (that which he or she does not own) and buying low (covering his or her short position) if all goes well. Either speculating strategy is based on a price forecast that can come from various sources or analytical methods. Some people distinguish the speculator from the true investor. It is thought investors have a more substantive fundamental rationale to base their investment decisions on, contrasted to the (naive) speculator who makes a trade more or less as a gambler would place a bet on the outcome of a roulette wheel.
Speculation may also be differentiated to that of a hedged (risk reducing) position. For example, corn farmers' wealth depends heavily on the price of corn. At the time of planting corn seed, the farmers do not know what the corn price will be when they sell it at harvest time. The farmers as producers are essentially speculating on a high corn price favorable to them compared to their production costs. Likewise the supermarket may be the buyer of the corn and desires low corn prices for its planned purchases so as to be able to offer low prices to its customers. The supermarket could speculate on corn by acquiring inventory now for sale later. In contrast to speculation, the farmers selling corn and supermarket buying corn could enter into transactions that reduce or eliminate their price risk in corn. An example of such a transaction would be for the farmers to sell corn futures contracts and the supermarket to buy corn futures contracts for a later date in the growing season.
Speculators may be classified as to type with respect to the time of their holding period. Speculators who invest in a position, long or short, for only a few minutes are called scalpers, for a day at a time are day traders, and for beyond a day are named position traders. These terms are more commonly used in the futures markets whereas the stock market would distinguish between short-term versus long-term speculators. Regardless of the category that speculators are placed in, their capital is placed at risk in an investment with the belief (or hope) that the price will subsequently go up (if long) or down (if short) in order to make a profit.
Speculation has been attributed as the cause of some spectacular crashes in the markets over the years. Some of these speculative markets are referred to bubbles. The tulip bulb market in the Netherlands in the early 1600s represents a speculative market. Tulip bulbs, of all colors, were sold in the Netherlands as part of the agricultural market beginning at an approximate equivalent of $5. As individuals saw the price of tulip bulbs climb, the market attracted an increasing number of investors who speculated on the future price of bulbs. The value of tulip bulbs is purely based on the forecast of its price determined by supply and demand. There is no use for the bulbs except for flower gardens. That is, the intrinsic fundamental value of future cash-flow-generation ability does not exist with tulip bulbs.
Nevertheless, people witnessed a forever rising tulip bulb price market and speculated that if they were to buy now, even though the bulb had no value but for resale, a greater fool would come by later to purchase it for an even higher price. This speculative bubble finally burst, around a $5,000 price per bulb, and tulip prices came tumbling down. Those speculators who bought a bulb at a high price were stuck with it. Of course, they could plant the bulbs and have a pretty garden. Similarly, speculators have been blamed, at least in part, for the downfall of other bull markets, where prices increase without apparent financial reason. The famous stock market crash of 1929 and the Japanese real estate and stock market crash of the early 1990s have been attributed to the frenzy caused by speculators speculating on the investments.
[ Raymond A. K. Cox ]
Kolb, Robert B. Futures, Options, and Swaps. 2nd ed. Malden, MA: Blackwell Publishers, 1997.