While speculators sometimes get a bad rap during market declines, they are a necessary and pivotal requirement of the stock market. Speculators buy and sell stocks, attempting to anticipate price movements in order to profit. Many traders and investors fit into this category. Speculation, being a key role in the markets, has both advantages and disadvantages, which are often magnified during times of emotional highs and lows. By understanding speculation, investors can better prepare themselves for the ups and downs of financial markets.
Markets are in continual flux based on always changing information collected from around the globe. One of the main causes of price change is supply and demand. If speculators feel a price rise in a stock is warranted, they will attempt to purchase as much of it as they can within their limits and tolerance or risk. Because the supply of shares is limited, speculators' buying increases demand the price of the stock goes up. The same scenario plays out in reverse if speculators feel a stock is ripe for a fall. They sell their stock, increasing the supply. If the selling is not met with equal demand, the stock price will drop. Speculators are not involved in a company's business, but focused solely on the movement of the company's stock price and their ability to profit from it.
Speculator vs. Typical Investor
Speculators play a key role in driving trends, both up and down. As this group considers available market information -- such as earnings reports, news or price patterns -- they buy or sell, pushing the price of a stock. If many speculators agree, a trend in price is created. If speculators don't agree on direction, the market is choppy and is said to move "sideways." The typical investor is not actively managing positions in an attempt to profit as a speculator might. Rather, typical investors usually invest in a company or fund for a long period of time and are less concerned with short-term ups and downs in the market. Investors attempt to profit from the long-term rise of a diversified portfolio, where active speculators may trade only one stock or just a few -- though some may actively trade in many -- usually within a shorter time horizon.
Effects of Speculators
There is a conventional view that speculators are the cause of market crashes, such as the great crash of 1929. No one group can be blamed in isolation, though. Markets are composed of many participants, all with different time frames and agendas. A massive stock market rise can't occur without the participation of nearly all market participants buying stocks, just as the ensuing crash can't occur without nearly all participants opting to sell. As prices climb, conventional investors often become speculators, investing more heavily, often on margin and deviating from their usually more prudent investment strategy -- the so-called "herd mentality." This creates excessive speculation and forces prices too high in too short a period. With capital exhausted, no one is left to continue buying and thus speculators, followed by investors, begin to sell. The same occurs as the market drops. Speculators and investors sell until no sellers are left, and then the market begins to rise again.
Pros and Cons
Making a profit is what all market participants are after, and therefore, speculation will always be present. This is a good thing for investors as speculators can help drive stock prices in their favor, resulting in investor (and speculator) gains. Also, speculators provide liquidity to the markets. Take away short-term speculators and it is much harder for investors to buy and sell at will. The downside of speculation is that price moves are often exaggerated. Speculation can push prices higher than reasonable levels (which can be good if investors move from stocks to cash at the right time) and, more devastatingly, can help drive down prices severely, resulting in large investment and economic losses.
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