Speculation is the buying, holding, and selling of stocks, commodities, futures, currencies, collectibles, real estate, or any valuable thing to profit from fluctuations in its price as opposed to buying it for use or for income - dividends, rent etc. Speculation is one of three market roles in western financial markets, distinct from hedging and arbitrage.
Speculators are sometimes comically pictured as speculating in pork bellies (in which a real market and real speculators exist) and often losing their shirts or making a fortune upon small market changes. Speculation exists in many such commodities but, if measured by value, the most important markets are in financial futures and other derivatives which involve leverage that can transform a small market movement into a huge gain or loss.
Type of speculators
Most non-professional traders lose money on speculation while those that do make money tend to become professional. Occasionally some dramatic event will occur such as the effort of the Hunt brothers to corner the silver market or the currency speculations of George Soros.
Many "investors" in the stock market are actually speculators betting on a gain in price "buy low sell high".
In fact, it is hard to differentiate a speculator from an investor. The degree of leverage, the length of holding, the frequency of operations might be factors. But there is a degree of speculation in every investing decision, and even in every life action that supposes to anticipate the future. Speculation is one of the essential human traits.
The economic role of speculation
The roles of speculators in a market economy are to absorb risk and to add liquidity to the marketplace by risking their own capital for the chance of monetary reward.
For example, if there were no speculators in a certain market, say in pork bellies, the only participants in that market would be the producers (pig farmers) and consumers (butchers etc). With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell pork bellies will be forced to accept an illiquid market and market prices that have a large bid-ask spread. A speculator (e.g. a pork dealer) will exploit the difference in the spread and, in competition with other speculators, reduce the spread thus creating a more efficient market.
Another example of the value of speculators is the ability of a pig farmer to sell his pork on the futures market at a known price ahead of its production.
Some perverse effects
Auctions are a method of squeezing out speculators from a transaction, but they have their own perverse effects; see winner's curse.
Sometimes speculative purchasing can cause particular prices to rise above their "true worth" simply because the speculative purchasing is artificially increasing the demand. Speculative selling can also cause prices to fall below "true value" in a similar fashion. In some situations price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise. This creates a positive feedback loop in which prices rise dramatically above the underlying "value" or "worth" of the items. This is known as an economic bubble (or sometimes a speculative bubble). Such a period of increasing speculative purchasing is very often followed by one of speculative selling in which the price falls in a crash (see stock market crash). This is very often even more dramatic than the period of rising prices.