Speculators make money by purchasing stock and hoping for a price increase. Their strategy differs from that of investors who buy stocks and hold them for a long period to earn dividend income. All stock investing brings some risk, but the level varies based on your strategy. Higher returns often require a riskier strategy. The best strategy for you depends on your age, risk tolerance, tax situation, family size, income and the amount you can invest. You can consult a broker for help developing a trading strategy, or you can save money on commissions by doing your own research with an online trading account.
Effects of Speculation
Increased activity by speculators can have a significant effect on a stock's price. The collective response to earnings, price patterns and breaking news creates momentum. If speculators believe the stock will increase in value, their purchases might drive the price up. On the other hand, speculators' loss of confidence can send the price into a freefall. Conflicting opinions lead to sideways movement in which volume might be high but the net effect on the price is minimal.
If your broker allows margin trading, you can borrow against the securities in your account to purchase more stock than you could otherwise afford. This is helpful when you think a stock is about to skyrocket and you would like to purchase as many shares as possible. Depending on your broker's terms, you might be able to borrow as much as twice the value of the account. However, you're charged interest on the loan until you pay it back. And you can get into trouble if the stock price drops instead of rising. The broker may issue a margin call that would require you to cover the amount of the loan within a specified period.
You also can purchase an option that gives you the right to trade a stock at a certain price before the expiration date. "Put options" allow you to sell a stock, and "call options" allow you to purchase a stock at the specified strike price. There's no obligation to exercise the option before it expires, but you lose the money you paid for it if you don't. Ideally, you want to exercise your option when the difference between the market price and option price gives you the greatest profit.
Another speculation strategy is to make trades in opposite directions to hedge your investment and reduce the overall risk present in your portfolio. You can purchase shares of stock you think will rise, plus a put option to sell at a slightly lower price. This will limit your potential loss if the stock tanks, but it lowers your overall profit because you will lose the option price even if you realize your best-case scenario. You also could hedge a risky investment by diversifying your portfolio with bonds, mutual funds and lower-risk stocks.
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