Financial Speculation, Meaning and How It Works

There are many investors who try to implement the most disparate strategies in order to obtain the maximum profit, in the shortest possible time. A clear example of this is financial speculation, which presents itself as an activity aimed at obtaining and maximizing profits in the short term. All this in the face of some risks.

Understanding what financial speculation is and how it works, therefore, turns out to be fundamental for every aware investor. In this article we will explore the mechanisms behind this activity, paying particular attention to the current legislation.

What is financial speculation: meaning and definition

The term financial speculation refers to the operations of buying and selling financial instruments with the intent of obtaining a profit by exploiting price variations in the short - medium term. Unlike traditional investment, which aims at stable capital growth in the long term, speculation is carried out taking into account market forecasts.

But not only that, it is generally carried out using high-risk strategies in order to maximize profits. Going into detail, financial speculation can be defined as the set of operations for buying and selling financial assets, such as stocks, bonds and currencies, carried out with the intent of profiting from price fluctuations.

How financial speculation works and how it operates

Financial speculation involves the purchase and sale of financial instruments, such as stocks, bonds, currencies and raw materials. All of this, as already mentioned, with the hope of obtaining a profit by exploiting price fluctuations, rather than implementing a long-term investment strategy. Below we will see together how this market strategy works and how it operates.

How speculation works

To implement a financial speculation strategy, the interested parties first carry out an analysis and forecast of market movements. In particular, they carry out a technical or fundamental analysis, in order to try to understand how the prices of a certain asset, such as a currency or a stock, will move.

All this starting from the assumption that the aim of a speculator is not to hold an asset for a long time. Rather, the objective is to buy when the price is low and then sell when it increases and vice versa.

In order to gain the greatest possible advantage, it is also necessary to exploit the so-called financial leverage. The latter offers speculators the possibility of carrying out operations with a higher value than would be possible with the initial capital alone.

How does it work?

Financial speculation can be carried out in various markets, such as the stock, currency and derivatives markets. In the case of the stock market, speculators try to predict the various movements and, consequently, buy shares on the stock exchange. In particular, if they believe that the value of a share will increase, then they buy it and then resell it when the price is higher. If, however, they believe that the value will decrease, then they can opt for short selling. That is, they sell securities that they do not yet own, and then buy them back at a lower price and thus obtain a profit.

Those who operate in the currency market, on the other hand, can exchange them and try to profit from the variations in the exchange rates between different currencies. For example, if they think that the euro will appreciate against the dollar, they buy euros and sell dollars. As for derivatives, such as options and futures, we remember that these are financial instruments whose value depends on the performance of another asset. Speculators can use these instruments to bet on future price movements even if they do not physically own the reference asset.

When a speculative bubble occurs

A speculative bubble occurs when the prices of an asset, such as stocks, real estate or cryptocurrencies, increase in an exaggerated way compared to their intrinsic value. All because of excessive demand that is fueled by an unrealistic expectation of future earnings. Such price increases are often driven by speculation, which sees investors buy an asset not so much for its fundamental value, but with the hope of reselling it at a higher price.

Going into detail, a bubble forms when speculative price movements become unsustainable, so much so that the market is no longer able to support the inflated value of the asset. All this leads to a price collapse.

Crime of financial speculation

financial speculation in itself is not considered a crime. The situation is different when illegal behaviors such as market manipulation, abuse of privileged information or fraud are found. These situations, in fact, are configured as a serious crime for which there is a risk of incurring serious consequences from both a criminal and administrative point of view.

For example, market manipulation occurs when a person or a group of people tries to influence the price of a financial security through deceptive practices, such as wash trading or pump and dump. Abuse of privileged information, or insider trading, on the other hand, occurs when a person uses non-public information, but relevant to the performance of a security, in order to obtain financial advantages. This information, if used to speculate on an asset, is considered illegal.

Practices implemented to deceive investors or that conceal crucial information to make speculation fraudulently are punishable by law. This type of fraud occurs, for example, when incorrect or misleading information is provided to attract investors.

Financial speculation, some examples to understand

Financial speculation consists in buying and selling financial assets with the intent of obtaining a profit by exploiting price variations. Unlike traditional investing, speculation aims to obtain short-term gains, in exchange for a risk that is often high. There are several cases of financial speculation.

• High-frequency trading. Some companies use advanced algorithms to perform thousands of operations per second and take advantage of small price variations.
• Currency speculation. The speculator can decide to buy euros when the exchange rate with the dollar is low, and then resell them when it is higher.
• Short selling. A person can borrow shares from a company and immediately sell them because he thinks the price will fall. If the price falls, he buys them back at a lower price and then returns them to the lender. In this way he can collect the difference.
• Pump and Dump in cryptocurrencies. In practice, some investors buy a little-known cryptocurrency and try to promote it on social media to attract investors. When the price rises enough, they proceed to sell quickly, leaving assets with a collapsed value to the latest arrivals.

These, it is worth remembering, are just a few examples of financial speculation. In fact, there are various strategies that can be implemented to try to obtain maximum profit in the short term, in the face of a risk that is often high.

Original article published on Money.it Italy. Original title: Speculazione finanziaria, significato e come funziona