“Speculation is to know how the market will move before it does.”
- John Maynard Keynes
Speculation plays a key role in stock markets. The stock market and all its fluctuations are entirely based on millions of transactions that occur between buyers and sellers each day. Each of these buyers and sellers has different reasons for their activity, but all, at least a little bit, are based on speculation. Thus, speculation is not limited to speculative stocks—stocks with a high degree of risk.
Speculators look for opportunities everywhere. They are ‘arbitrage seekers’. A real speculator is aware of how much risk he takes and his expectation of high reward.
It is important to note that intelligent speculators are not gamblers. They are meticulous. They know the extent of the risk they take and follow strict methods and rules.
How to speculate: Lessons from a trader
Jesse Lauriston Livermore was a gifted speculator. He kept track of every move he observed on the stock market. Thanks to his carefulness, he succeeded to develop principles that help us to understand how to speculate. Whether you are a risk-taker or a careful investor, reading this article will make you a better decision maker.
You’ll learn that choosing to speculate is a strategic choice. It requires a real commitment of time and energy. Let’s see what he has to teach you on how to speculate:
1. Never act on tips
Never act on tips. Best-case scenario, your source was lucky. Worst-case scenario, you lose money and a friend. If someone is right, why would he or she share a good idea to make money?
When someone gives a tip, there are chances that he did not dare to seize this so-called opportunity. Or that he did seize it. In the latter case, the tip is already old news and you will just comfort his position. So remember: Never act on tips.
2. Speculation is hard work
Speculation is not an easy way to become rich. Indeed, as you do not make some quick money in law or surgery, you will not by speculating on the stock market. Speculation involves effort and it takes time.
3. There are times when you should speculate and times when you should not
Speculating is exciting! It creates the same set of emotions than gambling. So the more you speculate, the more you want to speculate.
It’s not always time to speculate. Sometimes, the market does not present the significant opportunities that you can seize. If you constantly speculate, you will sometimes take a lot of risk for small rewards. Risk is part of the game. Yet, you should only take some risk when the reward is likely to be significant.
In speculating like in life, patience is a key. Although it is hard to wait for opportunities to come out, it can be really profitable.
4. Form an opinion as to what the next move of importance will be.
There is one thing that good speculators have to do well: anticipating future movements. You need to spot triggers. Anticipate the psychological effect of a particular piece of news on the mind of the public. Sometimes, a piece of news will not affect the market. There is no effect because the market is either overbought or oversold.
To speculate, you have to follow three steps
1. Form a definite opinion on stocks;
2. Wait until the stocks become active and confirm your opinion;
3. Then back your opinion by buying or shorting.
Livermore highly recommended waiting for the market to confirm your opinion with a strong movement. Why should we wait?
Livermore pointed out that we may be right on anticipating future movements of importance. But the most difficult part is to determine when it will arrive.
5. Respect your stops
Speculators have to insure themselves against considerable losses by taking the first small loss. When you buy stocks, decide at what price level you will give up your position. We all make mistakes, especially on the stock market. The solution?
Put a price limit, it guarantees to minimize losses in case we were wrong.
6. Develop your own guide
Although Livermore’s advice is a must-to-know, no guide can be 100 percent right. Recommendations mostly depend on context, personality and time. There is no permanent truth.
It is up to you to learn from your mistakes as much as possible. And then adapt to what you learned.
How to develop your own guide on speculation
Livermore recommended studying price movements. Keep records of price movements and take the time element into consideration. It helps to understand how the market reacts to news and then to anticipate coming movements of importance.
7. Learn to recognise danger signals
Spotting danger signals will help you to minimize the losses and wait for more favourable opportunities.
What is a danger signal?
Danger signals are weird market movements. Be vigilant when you observe that stock prices do not move as you anticipated. If you do not understand why the stock price is going downward, sell and wait for the stock to act according to your forecast.
If the stocks start a downward trend, no one can say when it will stop. It is wiser to sell, rather than to wait too long and lose lots of money.
Three don’ts of speculation
1. Don’t sell because a stock seems too high
If the stock price seems high, do not sell without thinking carefully about it. Instead, you must decide whether the price could go higher. If you have no basis justifying an upward trend, it may be wise to sell.
Livermore recommended waiting for a danger signal. He preferred losing a bit because of a slight drop rather than missing the opportunity that the stock goes higher.
2. Don’t buy because the stock price has decreased from a previous high
When the stock price just dropped, it is likely that the price will keep its bearish trend.
If you have not anticipated this movement, do not buy more stocks. You might think it is an opportunity to buy cheaper stocks. But you will just increase the risk of losing money.
Take your loss and buy again later, when the stock prices move according to your forecast.
3. Don’t average losses
Averaging losses happen when someone who just bought some stocks keep buying, even though the stock price is declining.
This strategy is bad because you could lose money. When we average losses, we justify that we were wrong. Instead of minimizing the loss by selling the stocks, we take more risk speculating on stocks we cannot predict.
As investors you should try to invest in the stock market based on fundamentals. There are two types of categories, investors and traders. Traders get involved in speculation a lot. Regulators all over the world do not encourage speculation since a large degree of speculation might harm the stock market in the long run.