Some common financial instruments that speculators use are stocks and financial derivatives. Speculation involves trading a risky financial asset with the expectation of capturing a substantial gain from the price fluctuations in the market price.
Stocks are a type of financial security that signifies ownership in a public company. Speculators use stocks in an attempt to capture a gain in the price fluctuations. For example, assume a speculator looks to purchase 1,000 shares of company ABC because he believes the company will beat its earnings per share (EPS) and revenues estimates, along with raising full year guidance.
Generally, buying or shorting a stock ahead of earnings has a substantial amount of risk due to the increased volatility, and the speculator may lose a large portion of his initial investment. However, this risk is compensated by the chance of large gains if the speculator is right on his trade.
Financial derivatives, such as options, are also involved in speculation. Options are financial derivatives that represent a contract sold by one party, the option writer, to another party, the option buyer. The contract offers the buyer the right, but not the obligation, to buy or sell a security at a predetermined strike price on or before a specified date.
Speculators use options in an attempt to capture a substantial gain in the price fluctuations of the contracts. For example, assume a speculator writes a call option and receives the premium from the option buyer to take on the risk of the underlying asset price increasing in value. Under the contract specifications, the option writer will need to deliver the underlying asset if the asset exceeds the option's strike price.
The option writer who sells the call option believes that the underlying asset's price will drop below the option's strike price during the life of the option. If the underlying price is below the call option's strike price and the contract expires, the option writer will receive his maximum profit. However, his loss potential is theoretically unlimited if the stock price increases above the strike price.
