What Is Speculation?
Speculation is a method of short-term investing where traders essentially bet on the direction that an asset's price will move.
Who Is a Speculator?
Technically, a speculator is anyone who buys or shorts securities with the expectation of a favorable price change.
A speculator believes that XYZ Company stock is overpriced, so they may short the stock, wait for the price to fall, and make a tidy profit.
It's possible to speculate on virtually every security, though speculation is especially concentrated in the commodities, futures, and derivatives markets.
Hedging vs. Speculation
To really understand speculation, one must understand how it differs from hedging. Assume part of your investment portfolio includes shares of Company XYZ, which manufactures cars. Because the auto industry is cyclical, Company XYZ shares will probably decline if the economy starts to deteriorate.
If you want to protect this investment (ie. hedge your investment), one way is to buy defensive stocks. You may choose "non cyclicals," which are companies which sell basic necessities like toothpaste or toilet paper. During economic slumps, these stocks tend to hold – or increase – their value, which could offset the loss in XYZ share value.
How Speculation Differs from Hedging
A speculator wouldn't follow this strategy. If a speculator purchased stocks from a food producer, they would do so simply because they believe the stock value will increase.
Does Speculation in Economics Increase Volatility?
Speculation can increase short-term volatility (and thus, risk), inflate prices and lead to bubbles.
Speculative History Example
In the United States, the subprime mortgage crisis was caused by speculators who bet that home prices would continue to increase the demand for purchased houses. These were intended to be “flipped” for a profit (often using leverage) which increased the demand for housing. This further raised prices, eventually taking them beyond the "true value" of many real estate markets.
The frenzied selling that ensued is typical for speculative markets.
Why Is Speculation Important?
Some people may see them as dangerous gamblers, but speculators actually provide much-needed liquidity to markets and are therefore a vital component of market efficiency.
For example, without speculation, many commodities markets would grind to a virtual halt. With fewer participants in the market, bid-ask spreads would widen and it would be much harder for buyers and sellers to find each other. The resulting illiquidity would dramatically increase the risk in that market.