From Volatility.RED

Speculation or speculating is the main thing that traders do when they are taking on positions in the markets. Speculating is the real purpose behind why people would be interested in trading any market. Of course, for most people, the purpose of trading is to make money. However, what we actually do in the business of trading is something called Speculation.

A technical definition of speculation is:

Speculation is the act of trading in an asset or conducting a financial transaction, that has a risk of losing some, most or all of the initial capital, in expectation of a considerable profit. With speculation, the risk of losing money is offset by the possibility of a large profit. Without the potential for large profits, there would be a limited incentive to speculate. Speculation is sometimes confused with gambling, the key difference is that speculation is generally taking a calculated risk and is not dependent on chance alone, whereas gambling depends on totally random outcomes or chance.

It is true that there are many people who treat trading just like they would treat gambling. This is why trading sometimes gets a bad name in the media. Unfortunately, many people who trade are indeed gambling, but some of them simply don’t know that is what they are doing.

Not everyone who comes to trading is fortunate to get the right training and have the correct mental frame of mind to be successful. This is why we will spend some time in this article focusing on ways traders can speculate professionally rather than like a gambler.

Trading is a Business just like any other Business

An interesting thing is that most people who come to the business of trading don’t know that what they are actually doing is gambling. They just know that they have been taught a system or trading approach and that this new idea is going to help make them more money. However, just because certain people treat trading like gambling, this doesn’t mean that all forms of trading are pure gambling. Quite the opposite actually.

New traders don’t seem to know that when you approach the business of trading you have to arm yourself with all the traditional tools that you would need if you decided that you wanted to open up a local pizza shop or a clothing store, for example. Traders need a plan of action and a way to measure their results. They need a strong understanding of how to manage their finances risks so that they don’t go out of business.

No one in their right mind would put up tens of thousands of dollars to open up a brick-and-mortar store without a well-thought-out business plan. But so many traders come to the market with unrealistic expectations of what is achievable in a short period of time without carefully examining all the risks. This is one of the reasons why the term “Trader” gets a bad rap in the media.

Professional Speculation

There is a professional way to go about speculating without risking your entire financial future every time you place a trade. As long as you are willing to put in the work then you will have a better chance to get to your goal of becoming a consistently successful trader in the Forex market.

For those of you that are or want to be scalpers, day traders, swing traders, or anyone who is trying to make money from the markets, speculation is our sole purpose when we are trading. Speculation simply means that we are trading for profit rather than any intrinsic gain in investment or exchange of goods and services.

Speculators are people that are not conducting any business or doing anything of tangible value other than attempting to generate a profit from the markets. They may be trading on their own account, a prop account, or client funds through a managed account program. Some speculators might be trading on borrowed money and this is definitely NOT recommended in doing. There are definitely plenty of other better and safer ways to go about speculating.

One big concept thing to keep in mind is that most, if not all, hedge funds, investment banks, and mutual funds are in fact speculating as well. The only difference is that they are doing it for their clients and not just for themselves like retail traders are. The other big difference is that they are doing it with a lot more money than retail traders. But over time retail traders can still absolutely make a great living trading their own personal accounts.

At the very least 90% of the trading activity that takes place in any modern market is some form of speculation. Let that sink in for a moment. At least 90% of all trading activity is pure speculation. The rest is for people and companies exchanging one currency for another so that they can go on holiday or pay their staff in different countries than their home country.

Financial Markets Cannot Function without Speculators

It’s very important to understand the underlying reasons that trading exists and where speculators fit into the overall ecosystem of the markets. Although they only trade for pure profit, they also serve an incredibly important purpose to all markets in those markets.

Speculators add enormous amounts of liquidity to all modern markets. This is a key point to understand. The liquidity they add is the lifeblood of ALL modern financial markets. The markets need every speculator they can attract because we bring in lots of liquidity.

Speculators tend to get a bad name, and to the uneducated person, it seems like this kind of trading activity is potentially destabilizing to the financial system. This is completely wrong and nothing could be further from the truth. The reality is that speculators provide one of the most important aspects of all markets which is to provide massive amounts of liquidity.

If a financial regulator were to remove speculators from any modern market the liquidity would dry up overnight. This would make it absolutely impossible for companies and banks to conduct their day-to-day business operations at reasonable or fair prices. Efficiency and liquidity would be virtually gone and basic transaction costs and spreads would go way up.

The fact is that there would be no way for these companies to do business in an efficient manner which would eventually force them to pass the extra costs of doing business down to the consumer. This means that you and I would have to pay more because some regulator thought they knew what was best for financial markets (hint: regulators get it wrong most of the time). Generally, without speculators everything would be inefficient and cost a lot more. This would be bad for everyone involved.

To understand the role speculators play think about the futures market. What if a farmer had to wait weeks and months for a profitable price at which to sell his meat or vegetables? Obviously, the produce would spoil and go to waste making the farmer really unprofitable and unhappy. This would cause the farmers excessive financial problems. This sounds silly because we are so use to having unlimited liquidity in the commodity and futures markets. All of the benefits that these types of people and companies receive are all thanks to good old speculators.

Without speculators, there would be no stability in the global financial markets because there would not be enough liquidity to do business in an efficient way.

Lack of Liquidity Example

Think about the former United States listed company Lehman Brothers back in the great recession of 2007-2008 for a moment. Lehman Brothers didn’t collapse because there was no business to be done or there were no employees to keep things moving. They collapsed because they didn’t have enough liquidity to support the company’s essential overnight funding for one night, ONE NIGHT! This caused the entire company to collapse overnight. In this case, it was the credit lines to fund their overnight essential capital requirements that had no liquidity (don’t worry if you don’t know what that means, just try and understand the main idea).

At this historic time, the credit markets had ground to a halt and dried up to a point where there was literally no way to do business at all let alone efficiently. Because Lehman Brothers was so highly leveraged and dependent on the credit markets, not having the necessary liquidity killed them overnight.

The government decided to not bail out Lehman Brothers and let them fail. However, once they saw how bad this failure was on the markets they decided to start bailing out virtually any large bank or investment house so that the financial system did not completely collapse and set the death of capitalism into motion. Most people don’t realize just how close we were to a total global financial meltdown.

How important do you think liquidity was to Lehman Brothers? A 158 year old company gone, just like that, all because of not enough liquidity in the credit markets to borrow efficiently for one night. We can always go a little bit deeper and talk about the blatantly abusive accounting practices Lehman Brothers was using but in the end, it was a lack of liquidity that finished them off regardless.

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