Free Stock Investing Education

Stock Speculation

Terminology

Stop Loss

When a stocks price drops below a predefined price level, the stock is sold. This is a money management strategy to limit capital losses.

Technical Analysis

The basis of technical analysis is to visually display a stocks price history on a chart. This allows a stock trader to study the stocks price behavior using technical indicators and chart patterns.

Volatility

Volatility is a measurement of a stocks price fluctuation. Stocks with large price swings are more volatile than stocks with small price swings.

Stock Speculation - Speculative Trading; picture of an investor using a phone and pressing the buttons while looking at a stock chart to see what trade to place

Speculative

Trading

Trading with the aid of fundamental information

The difference between speculative investing and speculative trading is simply the difference between investing and trading.

Difference between investing and trading:

  • Investing is the process of following the increase in the fundamental valuation of the company irrespective of the stock price.
  • Trading is the process of following the stock price movement irrespective of the fundamental valuation of the company.

By the very nature of businesses which take considerable time for changes to be reflected in their fundamental valuations, this makes investing a long-term proposition. On the other hand stock prices are highly volatile and move extremely quickly which makes trading attractive as a short-term proposition.

When a market participant speculates on the price movement of a stock, they are referred to as speculative traders. This leads to the issue with stock trading which is sometimes cited by the financial press as speculation.

While stock trading strictly speaking is speculating, a distinction is made between the stock trading and speculative trading to distinguish between the different approaches used.

The term stock trading is usually used in reference to traders who exclusively utilize technical analysis for their decision making process. They are often referred to as technical traders and can also be referred to as either technicians or as chart pattern traders. Technical traders include day traders, swing traders and position traders.

While technical traders are speculating on the future price movement of a stock, their decision making process is based solely on the stock's price history. In contrast, speculative traders base their decisions largely on fundamental considerations while incorporating technical charting analysis. Also technical traders usually have a fairly short time frame while speculative traders usually have longer time frames which can extend beyond one year.

The Speculative Trader

Speculative traders can be thought of as fundamental traders who speculate on the future price movement. Probably the most famous speculative trader of all time is the famous investor - Jesse Livermore who amassed a fortune speculating on the markets.

A speculative trader has the same options as a speculative investor but also has some additional options.

Speculative trading:

  1. Trade an investment grade stock based on its future valuation continuing as its present rate.
  2. Trade an investment grade stock based on a change in its future valuation.
  3. Trade a speculative stock which is basically fundamentally sound based on its future valuation continuing as its present rate.
  4. Trade a speculative stock which is basically fundamentally sound based on a change in its future valuation.
  5. Trade a speculative stock which is financially distressed based on its future valuation continuing as its present rate.
  6. Trade a speculative stock which is financially distressed based on a change in its future valuation.

The speculative trader can speculate on the price movement of either an investment grade stock or a speculative grade stock.

Speculating on the price movement of an investment grade stock is illustrated below in Figure 1.

Figure 1. Speculative trading with an

investment grade stock

Speculative Trading - graph showing stock of investment grade heading in a downtrend and bouncing up

From Figure 1. above, the speculative trader has identified a small company which is determined to be of investment grade. The speculative trader takes an entry as the stock price is well below its fundamental valuation and also below its book value. While the stock is in a downtrend, the speculative trader enters on a bounce in stock price and places a stop-loss below the Relative Low.

A technical trader may see the same stock and come to the conclusion that since the stock is in a well defined downtrend that a short position would be appropriate.

Thus the speculative trader and the technical trader can come to the exact opposite conclusion regarding which direction to trade the stock.

Speculative traders can also speculate with stocks on the short-side by speculating that the stock price will decline.

Speculating on the price decline of a speculative stock which is financially stable is illustrated below in Figure 2.

Figure 2. Speculative trading with a

fundamentally sound speculative stock

Speculative Trading - graph showing stock of investment grade that is fundamentally sound declining in stock price downwards

From Figure 2. above, has identified a speculative stock which is financially stable but has been struggling with its revenue and earnings. The earnings forecasts are for an increase in earnings; however the stock's rally has significantly outpaced any realistic increase in valuation. The market has priced in an earnings figure that is probably based on a whisper number.

After the earnings are released, even if they match the forecast estimates, the stock will likely sell-off due to profit taking. For the stock rally to continue, the earnings results would have to exceed what the market has priced into the stock.

The speculative trader decides to short sell the day before the earnings release. If the earnings release does not reach the forecast estimate and the earnings is merely much the same as previous releases, then this stock will likely be sold back down to its valuation line.

A technical trader may see the same stock and come to the conclusion that since the stock is in a well defined uptrend that a long position would be appropriate.

Thus the speculative trader and the technical trader can come to the exact opposite conclusion regarding which direction to trade the stock.

Stock Speculation - Speculative Trading; picture of two stock traders looking at an animated three dimensional chart plunging into the ground due to market crash to see if a trade is worth taking

Beginner Traders

Beginner traders whether they are speculative traders or technical traders or investors typically trade on the long-side and are often caught out when they trade speculative stocks.

A common pitfall for beginners is that they are keen enough to exit their trades at a profit, but when they endure a string of losing trades they become reluctant to sell at their stop-loss levels. They begin to notice that the stocks subsequently traded back to breakeven after being stopped out at a loss. This is the roller coaster nature of stocks.

The problem for the beginner trader is that they start to hold onto their losing trades after they trigger their stops by justifying that they will return back to their entry price. While this is an issue with an investment grade stock, it is disastrous with speculative stocks especially if they are financially distressed as the valuation has a high probability of continuing downward and the stock price may never return to their entry price.

Beginner traders who also incorporate short selling have the problem that some speculative stocks can significantly increase in valuation which can send the stock price soaring. Any beginner who did not exit their short position will endure a substantial loss.

Any stock trading requires a sound risk management strategy to be implemented otherwise trading will lead to nothing but losing.

Technical trading is appealing to beginners as they require no fundamental knowledge in order to participate. However incorporating fundamental considerations is the essence of speculative trading.

The series on Chart Investing gives the speculator numerous examples using charts as the primary means of tracking the stock price.

The series on Position Management gives the speculator numerous examples using stop-loss techniques that are suited to longer term trading and speculative investing.

If selling at a stop-loss causes the technical trader anguish, there are speculative strategies which are based on speculative short-term investing which do not even incorporate stop-loss tactics and are instead based on probability.

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Stock Analysis for Finance Students and Investors