Investment Pyramid - Speculation

If you've spent any time reading through investment literature, you've probably noticed that there are many, MANY possible ways to invest that we haven't mentioned in our discussions of mutual funds and stocks. Most of these methods actually are really speculation; taking substantial risks in the hopes of generating even greater returns.

Speculation is inherently risky; unlike investing (at least, passively investing in index funds or similar investments), it involves significant work, research, and frankly, more than a little luck, in most cases. My best advice regarding speculation is simply to limit your exposure. Keep at most 10% of your portfolio in speculative ventures, and then, only if you can afford to lose that money with no effect on your retirement and other long term plans.

If you decide to engage in some speculation (and again, there is no requirement that you must), there are plenty of ways you can go about speculating. Day trading stocks is one method, but of course, you run the risk of mixing your investments with your speculatory stocks. There are numerous other financial instruments that are used only for speculation:

Futures - Futures are contracts to secure the price of some commodities for a future date (hence the term, futures). The underlying goods can range from agricultural products (corn, cattle, soybeans) to raw building materials like lumber and steel. For producers and consumers, futures can serve to decrease the volatility of the market and help to limit future price risk. Selling a futures contract allows the producer to lock in their profit, and buying one enables the consumers to ensure their expenses.

For most investors, though, investing in the futures market involves trading contracts without intending to take physical delivery of the underlying goods. Depending on how the prices of the commodites change, the value of the futures contracts will change, leading to profit or loss for the investors.

Options - Options are financial instruments similar to futures. They enable you to lock in a price on a stock, bond, or other asset for a future date. Options come in two flavors, calls and puts: calls give you the right to buy the asset at a pre-arranged price (the strike price), while puts permit you to sell an underlying asset at the strike price.

Buying options is a method of hedging, enabling investors to ensure the future price they'll be able to buy or sell an asset in which they are interested. Buying an option doesn't compell the buyer to exercise the option (that is, buy or sell the underlying asset at the strike price), so the only money at risk is the cost of buying or selling the option. Selling options can be a way of generating funds (the price of the options), but there is the risk that you could be compelled to buy or sell the underlying assets at prices much worse than the current market prices.

Currencies - More commonly known by the term forex, currency trading involves currency pairs. Large international banks need to convert from one currency to another in the course of their business dealing. The market for these exchanges is the interbank or spot market.

Speculators in this market try to determine how the exchange rates of currencies will change, usually over short periods of time. They buy or sell pairs of currencies, representing the exchange rates between two different monetary systems. Profit or loss results from the movement of currency rates and the particular bet the investors have made.

(Beware of leverage with regards to these investments, particularly with options and currencies. Leverage essentially translates to borrowing money with the hopes of investing it and generating profit, enabling you to repay the loan and generate a larger profit than possible with your money alone. The advantage is that relatively little money can be used to generate a large profit; however, the disadvantage is that a bad investment can lose more money than you initially invested. Be very, very careful about the investments you choose, and be sure you know the largest amount of money you could end up losing if your speculation fails.)

Finally, I'd like to remind you that there's no reason to engage in speculation if you don't want to do so. It is certainly possible to create a complete and comprehensive investment plan without touching upon speculatory investments at all. Only engage in speculation if you have the funds available, can lose them without affecting your investment goals, and understand exactly what you're doing. If you don't meet all these qualifications, stick with investments lower on the pyramid.