What is a speculative share?

In the world of finance, the term 'speculative share' can raise eyebrows and generate buzz amongst investors. But what exactly is a speculative share? And what makes them attractive to investors? 

This article aims to provide a comprehensive understanding of speculative shares and their position in the stock market.

What are speculative stocks?

Speculative stocks are associated with higher risk and uncertainty than traditional, more established shares. 

These shares typically belong to companies in the early stages of development, facing financial challenges, or operating in industries with inherent volatility. We characterise speculative shares by their potential for substantial share price swings, both upwards and downwards.

Their high volatility compared to blue-chip shares, for example, still attracts many traders. It's an opportunity to make greater returns, although the investment risk has substantially increased. 

Traders use speculative stocks to speculate – that is, to make investment decisions based on the expectation of significant short-term gains or losses rather than long-term investment strategies. Speculative stocks tend to be penny stocks or emerging market stocks that the trader expects to become more widely known in future. 

Key characteristics 

The following factors can characterise stock market speculation;

• Short-term focus: Speculators are generally interested in profiting from short-term price movements, such as those occurring within days or even minutes, as opposed to long-term investors who hold assets for years.
• Emotion-driven: Speculators often make investment decisions based on market sentiment, news, and trends rather than fundamental analysis or company performance.
• Greater uncertainty: Events or factors that are difficult to predict can influence speculative activities, such as regulatory changes, social media trends, or unexpected news.
• Leverage: Speculators may use leverage, which involves borrowing funds to increase the size of their positions, further amplifying potential gains and losses.

Why invest in speculative shares?

Investors may choose to invest in speculative shares for various reasons. One primary motivator is the potential for significant returns. Since these shares are more volatile, they have the potential for rapid and substantial share price appreciation. 

Investors seeking high-risk, high-reward opportunities turn to speculative shares to capitalise on this growth potential. Speculative stocks have the potential to provide windfall profits, but the challenge is to find ways to limit losses if the trade doesn't work out. 

Speculative shares can provide diversification benefits for a well-rounded portfolio. Adding a small allocation of speculative stocks allows investors to balance their overall risk exposure and potentially enhance their overall returns. 

Some investors use speculative shares as part of their trading strategy to hedge against uncertain market conditions. For example, during a bear market, they may speculate on stocks expected to perform well in such conditions.

Investors can also use speculative shares to capitalise on particular situations. Speculative shares may include companies in unique situations, such as turnaround stories, mergers and acquisitions, or those with potential for explosive growth. 

Investing at the right time in such situations can lead to substantial gains in valuation. Similarly, speculators often trade on market sentiment, news, interest rate changes, or social media trends. 

Investing in speculative shares can allow traders to capitalise on short-term market fluctuations driven by emotional responses.

Why is speculation risky?

Speculative shares are inherently risky. Factors that contribute to this risk include:

• Volatility: Speculative shares are known for their price volatility, which can lead to significant and sudden changes in valuation.
• Lack of financial stability: Many companies offering speculative shares face financial instability or have limited operating history, increasing the risk of bankruptcy or failure.
• Market sentiment: Speculative shares are often influenced by market sentiment, news, and trends, making them more susceptible to irrational pricing and bubbles.
• Limited information: Information about these shares can be limited, making it challenging for investors to conduct thorough research.

Which sectors are the most speculative?

The level of speculation in different sectors varies. Some sectors are inherently more speculative than others. 

For example, mining and resource-sector exploration companies tend to be speculative because their success depends on finding valuable resources. Commodity prices and the success of exploration efforts can highly influence their valuations. Uranium miner and exploration company Paladin Energy Ltd (ASX: PDN) is a speculative share in this category, with mines in Africa, Australia, and Canada. 

Technology stocks, particularly those of smaller, emerging companies such as Brainchip Holdings Ltd (ASX: BRN), are known for their speculative nature. Investors often speculate on innovative technologies, startups, or companies with disruptive potential. These stocks can experience significant price swings based on market sentiment and expectations. Brainchip Holdings provides neuromorphic computing solutions, a type of artificial intelligence inspired by the biology of the human neuron.

Biotechnology is another sector that lends itself to speculative stocks. The sector is filled with companies researching and developing new drugs and treatments. Pharmaxis Ltd (ASX: PXS) is a good example. Pharmaxis is a pharmaceutical research company focusing on new therapies to treat inflammation and fibrosis. It has a portfolio of products at various stages of development and approval. 

The potential for regulatory approvals, clinical trial outcomes, and breakthrough discoveries drives speculation in this sector. A single positive or negative development can cause substantial price movements.

Renewable energy companies can also be speculative, particularly those focused on emerging technologies like solar, wind, and electric vehicles. Government policies, technological advancements, and market adoption rates influence these stocks.

Do investors typically buy or sell speculative stocks?

Buying or selling speculative stocks depends on an individual investor's goals and risk tolerance. Aggressive investors may actively seek speculative stocks as part of their investment strategy. They believe in the growth potential of these stocks and are willing to accept the associated risks.

Speculative stocks can present unique opportunities when significant share price movements occur due to market events, news, or company-specific developments. Opportunistic investors may buy speculative stocks when they believe there is a chance for short-term gains, such as after a positive earnings report or a favourable regulatory decision.

While speculative stocks are known for their volatility, some investors may buy them with a long-term horizon. They believe that, despite short-term fluctuations, the company's growth potential or disruptive technology will lead to substantial gains over time.

When speculative stocks experience significant price increases, investors may choose to sell their positions to realise profits. This is a common strategy for locking in gains and managing risk. Investors also often sell speculative stocks in response to adverse market events, such as a market correction or economic downturn. 

Investors who see their investments in speculative stocks declining in value may also decide to sell to limit their losses and prevent further damage to their portfolios. During times of heightened uncertainty, speculative stocks may see substantial sell-offs.

What are the different types of speculative investors?

Speculative investing can take various forms, each with a distinct approach:

• Day traders: Day traders buy and sell speculative shares within the same trading day, capitalising on intraday price movements.
• Short sellers: Short sellers take a bearish position by borrowing shares they believe are overvalued, selling them, and repurchasing them at a lower price.
• Bear, bull, lame duck, and stag speculators: These terms are often used to describe the market sentiment of different investment styles. 'Bears' are pessimistic, 'bulls' are optimistic, 'lame ducks' are inexperienced or losing investors, and 'stags' anticipate short-term gains.

How does speculation impact the market?

Speculation can significantly impact the stock market, influencing various aspects of market dynamics, including trading volumes, price movements, and market sentiment.

Speculation often leads to increased share price volatility. When traders and investors buy and sell stocks based on short-term price expectations or market trends, this can result in rapid and sometimes erratic price movements. Speculative trading can exaggerate both upward and downward price trends.

Speculation can create momentum in the stock market. When a share gains momentum due to positive speculation, it can attract more buyers, further driving up prices. 

Conversely, negative speculation can lead to a downward spiral as more investors sell, causing prices to decline. This means that speculation can contribute to market bubbles and subsequent crashes. Bubbles occur when the prices of certain stocks become significantly overvalued due to excessive speculation. When the bubble bursts, it can lead to rapid and severe market downturns.

While speculation can introduce volatility, it can also contribute to market efficiency. 

Speculators can help provide liquidity to the market, ensuring buyers and sellers are available for trading. This can help in price discovery and market functioning. 

Excessive speculation, however, can prompt regulatory authorities to implement measures to safeguard market stability. Authorities may impose trading restrictions, investigate market manipulation, or enact regulations to curb speculative excesses.

Worth the risk?

Investing in speculative shares can be a double-edged sword. While high returns are enticing, the risks are equally substantial. For those with a high risk tolerance and the ability to conduct thorough research, speculative shares may have a place in their portfolios. However, it's essential to approach speculation cautiously and diversify investments to mitigate potential losses.

Whether speculative shares are worth the risk depends on an investor's risk appetite, financial goals, and ability to navigate the intricate world of speculation. 

While they offer potential rewards, investors should approach them with careful consideration and, ideally, a well-diversified investment strategy.