Speculation in stock markets

Sanjiv Shankaran

SPECULATION, when used in stock market parlance, often evokes strong feelings because an influential section of people view it with suspicion -- as black and white -- in other words.

It is probably time to take a look at speculation again. The newspapers report that the stock market regulator, Securities and Exchange Board of India (SEBI), has initiated an exercise to study all the angles pertaining to short sales (selling securities without actually having them). Simultaneously, there are other developments in the existing mechanisms to aid speculation. Developments that suggest that we take a look at the many dimensions of speculation.

What is speculation?

That is a question that is unlikely to have a clear-cut answer. In the context of this article, speculation is described in two ways:

* Investors enter into a trade with the intention of ending it in the same settlement cycle;

* When they use the existing mechanisms of lending and borrowing to carry-forward their obligations to subsequent settlements.

* Having described it thus, it may be mentioned that speculation through borrowing and lending mechanisms is present in most markets.

Why is it present?

Speculation exists because it enhances the functioning of the stock market. The market for stocks itself exists because different people have different views on the same stock.

To explain, if all investors had the same view on every company, then everybody would want to buy at the same time or conversely, sell at the same time. The implication is that a market cannot exist because there is simply no one with a different view.

Unlike bank deposits, investing in stocks is, relatively, a risky business. There can be short, sharp fluctuations that result in big gains or losses. One way of looking at speculators is that they are a class of investors who are willing to take more risks on an average. And the thumb rule is that greater the variety (categories of investors), greater the likelihood of trades taking place.

Importance of volume in a market

The biggest advantage of speculation is that it increases the volume of the stocks traded. And volume is absolutely essential in creating a marketplace that functions smoothly.

Higher volume means that investors can enter and exit any moment. Equities are more actively traded than corporate debt in India, thus, providing investors with a handy investment avenue that yield cash at short notice.

Volume also plays an important role in price formation. Intuitively, all of us know if there arises a sudden huge sale in any market, the price will crash. Imagine the biggest shopping complex in a city centre being put up for sale in a real estate market that only sees sporadic sales. It will depress immediately the selling price of smaller shops in the vicinity.

Similarly, in a stock market that sees sporadic trades, orders for slightly bigger quantities will create huge swings in price. Thus, the price formation will be jerky.

On the other hand, when the market is liquid in terms of frequent trades taking place, the change in price is relatively smooth. Even if big orders come in, the depth in market results in relatively smooth changes taking place.

The downsides

The biggest fear with speculation is that it can accentuate sharp movements. By definition, speculators are the ones who are willing to take bigger risks. They are also likely to be first to panic in case of adverse developments. If they have traded on borrowings, they also happen to be at the mercy of creditors' decisions.

The Indian experience

In India, the experience with speculation has been interesting. Barely a decade ago, speculation was frowned upon by the regulators and the stock market witnessed a brief phase when the mechanism to carry-forward trades from one settlement to another was abolished.

Speculation was not the only thing banned. Trading after the close of the regular market has also been banned. It was not speculation as described earlier, but there was considerable overlap between people who participated in the market to carry-forward trades and the banned after-hours market for trading in shares.

In that context, the recent move on the part of a couple of stock exchanges to conduct extra trading sessions after the close of regular trading hours on all the markets, is interesting. All along, trading has often taken place -- termed as kerb trading -- after-market hours. There have been different ways through which the kerb deals have been introduced into the regular trading cycle. But there is greater danger imposed on the regular system when unregulated deals are brought into the regular trading cycle.

At one level, it appears almost that the move by a couple of stock exchanges is just an attempt to capture the business opportunities present in after-market trading.

Speculation and after-hours trading have often drawn the ire of regulators. Now we have an interesting case where they are all part of the system. They are dimensions of the market that can never really be suppressed; all attempts to curb them seem to fail.

In this backdrop it is a moot point if attempts to regulate short sales (a form of speculation) really work. Even in, arguably, the most sophisticated market in the world -- US -- a study by the regulators revealed that short sales restrictions were violated often.

The pros and cons of speculation are probably dimensions that the market will just have to live with. Heavy-handed regulation may simply be ineffective, because loopholes and violations seem one step ahead of enforcement.

Pic.: Traders at the Bombay Stock Exchange...

The biggest advantage of speculation is that it increases the volume of the stocks traded. And volume is essential in creating a marketplace that functions smoothly.

Picture by Paul Naronha