What is a Speculative Stock?
A speculative stock is a stock that a trader uses to speculate. The fundamentals of the stock do not show an apparent strength or sustainable business model, instead the trader expects that such things may one day come about for one reason or another. For the present moment, however, the price of the stock is comparatively low and holds a high degree of risk. This may be a penny stock or an emerging market stock that the trader expects to become much better known very soon. Many 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 a 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).
- Traders select stocks that appear to have great potential that is not yet realized.
- Such stocks are the subject of speculation, thus referred to as speculative stocks.
- Speculative stocks tend to be clustered into sectors or in various types: penny stocks, emerging market stocks, rare materials stocks, pharmaceutical stocks, and others.
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 if the trade works out in their favor. The challenge is to find ways to limit losses if the trade does not work out.
Often times, 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 may find a giant 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.
Although most speculative stocks tend to be early-stage companies, a blue-chip can occasionally become a speculative stock if it falls upon hard times 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 if it can manage to turn its business around and avoid bankruptcy.
Investing in Speculative Stocks
Speculative stocks generally outperform in very strong bull markets when investors have abundant risk tolerance. They under-perform in bear markets, because investors’ risk aversion causes them to gravitate towards larger-cap stocks that are more stable.
Typical valuation metrics like the price-earnings (P/E) and price-sales (P/S) ratios cannot be used for most speculative stocks since they are generally unprofitable and may have minimal sales. For such stocks, alternative techniques like the discounted cash flow (DCF) valuation or peer valuation may 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 may 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 look for companies that have good management teams, strong balance sheets, and excellent long-term business prospects.
Most investors should avoid speculative stocks unless they have the time to dedicate to research, while traders should be sure to use risk management techniques when trading speculative stocks to avoid sharp declines.