Speculative Stock

What Is a Speculative Stock?

A speculative stock is a stock that a trader uses to speculate. The fundamentals of the stock don't show an apparent strength or sustainable business model, leading it to be viewed as very risky and trade at a comparatively low price, albeit the trader is hopeful that this will one day change. This might be a penny stock or an emerging market stock that the trader expects to become much better known very soon.

Numerous traders are drawn to speculative stocks due to their higher volatility relative to blue-chip stocks, which creates an opportunity to generate greater returns — albeit at greater risk. Most long-term investors and institutional investors stay away from speculative stocks unless they are part of a mutual fund or exchange traded fund (ETF).

Understanding a Speculative Stock

Speculative stocks appeal to short-term traders due to their low share price and greater volatility compared to traditional blue-chip stocks. The greater volatility enables traders to realize windfall profits assuming that the trade works out in support of themselves. The challenge is to track down ways to limit losses in the event that the trade does not work out.

Oftentimes, speculative stocks are clustered in sectors such as mining, energy, technology, and biotechnology. While there is significant risk involved in investing in early-stage companies in these sectors, the possibility that a small company might track down a goliath mineral deposit, invent the next big app, or discover a cure for a disease offers enough incentive for speculators to take a chance on them.

Albeit most speculative stocks tend to be early-stage companies, a blue-chip can occasionally become a speculative stock in the event that it falls upon difficult situations and has rapidly deteriorating prospects for the future. Such a stock is known as a fallen angel and may offer an attractive risk-reward payoff in the event that it can manage to turn its business around and keep away from bankruptcy.

Investing in Speculative Stocks

Speculative stocks generally outperform in very strong bull markets when investors have plentiful risk tolerance. They underperform in bear markets because investors' risk aversion causes them to gravitate toward larger-cap stocks that are more stable.

Typical valuation metrics such as the price-earnings (P/E) and price-sales (P/S) ratios can't be used for most speculative stocks since they are generally unprofitable and may have negligible sales. For such stocks, alternative techniques such as the discounted cash flow (DCF) valuation or peer valuation might need to be used to account for future potential rather than current fundamentals.

Speculative stocks often account for a small portion of portfolios held by experienced investors because such stocks might improve the return prospects for the overall portfolio without adding too much risk, thanks to the beneficial effects of diversification. Experienced investors who dabble in speculative stocks typically search for companies that have great management teams, strong balance sheets, and excellent long-term business prospects.

Most investors should keep away from speculative stocks unless they have the time to dedicate to research. Meanwhile, traders who choose to trade speculative stocks should be sure to use risk management techniques to keep away from sharp declines. This is especially true during a recession when investors often pull their money from speculative stocks and seek safe-haven investments. A better strategy during more turbulent times is to invest in companies with low debt, great cash flow, and strong balance sheets.

A trader who invests primarily in risky stocks is known as a speculator.

Investing vs. Speculating

Investors and traders necessarily take on calculated risk as they attempt to profit from transactions they make in the markets. The level of risk undertaken in the transactions is the fundamental difference between investing and speculating.

Whenever a person spends money with the expectation that the endeavor will return a profit, they are investing. In this scenario, a reasonable judgment is made after a careful investigation that the endeavor has a decent probability of success.

In any case, imagine a scenario where the same person spends money on an undertaking that shows a high probability of failure. In this case, they are speculating. Success or failure depends primarily on chance, or on uncontrollable (external) forces or events.

The primary difference between investing and speculating is the amount of risk undertaken. High-risk speculation is typically much the same as gambling, whereas lower-risk investing uses a basis of fundamentals and analysis.

Highlights

• Traders interested in speculative stocks seek out securities that could seem risky at the moment yet appear to have great potential that is not yet realized.
• Speculative stocks tend to be clustered into sectors or types: penny stocks, emerging market stocks, rare materials stocks, pharmaceutical stocks, etc.
• Speculative stocks are high-risk, high-reward, and tend to appeal to short-term traders.
• Such stocks are the subject of speculation and are thus referred to as speculative stocks.