Sooner or later in your trading career, someone – maybe more than one person – will level what they imagine to be a deadly accusation: you are not trading, you are speculating.
There is a number of possible responses to this. One would be a heated denial, coupled with the assertion that you are engaged in socially valuable financial services. A shorter riposte would be: “So what?” Call it trading, speculation or anything else, it makes no difference – you are involved in these markets to make money.
A third, and more nuanced, reply may be to ask them what exactly they mean by “speculation.” Depending on their answer, it may help you to clarify the differences, if any, between trading and speculation.
Prices and odds
It is fair to say that, for some decades after the war, financial speculation had a bad name. Speculators had been blamed (not entirely fairly) for the 1929 Wall Street Crash and the post-war “Bretton Woods” monetary system sought to banish them, although they did find refuge in the freebooting ports of Macao and Tangier.
There is an irritating catchphrase that states that “two views make a market”. Irritating, because it is wrong. Provided a system of prices is in place, then just one view can make a market, for example the view that a certain security will rise in price.
Should one trader hold that view more strongly than a second, a market will be created by the former’s offer to relieve the latter of any holdings at a higher price.
A similar system is in place, of course, in the world of betting. If half those following the World Cup final think Country A will win and the other half think Country B, then you don’t need a system of odds. The two groups can simply bet against each other.
Odds are there to reflect different strengths of feeling about the likely outcome.
Speculators provide liquidity
So, is speculation just another word for gambling? In short, no.
Speculation, by contrast, involves trading on price changes that will happen anyway, as part of the routine functioning of a market economy. In contrast with race meetings and card games, the markets in commodities, foreign exchange, shares, and the rest are not staged to give punters something to bet on.
So, speculators, by standing on the other side of a trade, provide liquidity and help the market to function. Are all traders then speculators? The short answer, again, is no, although by definition all speculators are traders.
A trader can, of they so wish, pursue a cautious trading strategy. When the market is turbulent, they can stand back and wait for the calm to return. Swing trading is a classic example of a strategy suited to low volatility and which ought to be suspended in erratic conditions.
Six golden rules
However, “cautious speculation” is something of a contradiction. The speculator will trade when the price is right in terms of the ratio of risk to potential reward. It is impossible to stand on the other side of a trade when you’re standing back.
So, what are the golden rules of successful speculation?
- The speculator has no emotional attachment to any asset, strategy or market. That doesn’t mean the speculator cannot specialise in, for example, the dollar/euro exchange rate, but they must ensure they develop no feelings for it. When a more profitable area of speculation offers itself, they jump ship.
- Following on from this, historical patterns are of little interest to the speculator. Just because the Madrid stock market came good for you a year ago is no reason to plunge back in today. The speculator will eschew half-baked “correlations” between external events (such as sports results) and asset prices.
- Live in the present. Mainstream traders may take a longer view on the prospects for a particular asset, but the speculator will always bear in mind that the only price that matters is the current one, that the market has no interest in what they paid for the asset and that the focus must be on where the price is and where it is likely to go next. Speculators live in just two time zones: today, and tomorrow.
- Following on from this, a speculation that has gone wrong does not “owe” the speculator anything and the position needs to be closed before it sinks any further, taking the speculator’s money with it. No-one likes losses, but small losses help protect the market player from larger ones.
- A valuable old City expression states that “where there’s a tip there’s a tap”. Some take this to mean that a share tip is accompanied by a tap on the shoulder, but the more likely reference is to “tap”, meaning a reservoir of unsold shares. In other words, the tip is designed to offload these securities on to an unwitting trader or speculator. If they’re such a sure-fire bet, why is the tipper not buying them?
- Successful speculators embrace risk, they don’t hide from it. They are in the risk business, and relish the task of doing all they can, using research, experience and their wits, to mitigate risks. In doing so, they maximise their chances of making profit rather than loss – the goal of every speculator.
Finally, remember that, after the next financial crisis, you and your fellow speculators are bound to get the blame. That said, happy speculating!