A trader's guide to speculative bubbles

A speculative bubble refers to an asset’s price that’s inflated beyond its intrinsic value. While these usually spell financial trouble, when identified and traded correctly, you can benefit from these market shifts – here's how.

What is a speculative bubble?

A speculative bubble is a spike in the valuation of an asset that’s caused by speculation rather than any underlying factors. While initially driven by implied growth, the rising value is not sustainable, resulting in a sharp decline after reaching its peak.

A number of factors can give rise to speculative bubbles, including:

  • Low interest rates
  • Excessive demand
  • Increased risk appetite

These speculative bubbles inflate until a point of rupture, generally sparked by a crisis in politics, foreign currency, macroeconomic policy or industry. The actions of those involved in a bubble can be attributed to what is termed ‘herd mentality’, resulting in investors conforming to social pressure and groupthink.

Speculative bubble example

A well-known speculative bubble example is that of the 'dot-com' bubble. In the early 1990s, few people were using the internet in the US. But in 1995, Netscape Communications Corporation introduced an advancement that greatly accelerated the use of the internet, ushering in what has been dubbed ‘the internet age’.

Buoyed by the wave of optimism in the technology sector, investors quickly began to snap up shares in fledgling ‘.com’ companies. In the space of just five years, the NASDAQ 100 index rallied by 529%.

But by 1999 the tide began to turn as Y2K fears and disappointing earnings saw investors sell their shares in tech stocks. The inevitable crash caused the NASDAQ 100 to fall by nearly 80%. It would take another 15 years for the index to recover to its pre-crash peak.

How to recognise speculative bubbles

To recognise speculative bubbles, look out for:

  • Overwhelming optimism in a market
  • A surge in speculator interest
  • Rapid increases in an asset’s price
  • Reckless credit granting
  • Widespread popularity and media coverage

Types of financial bubbles

There are various financial bubbles, including:

Housing market bubble

Housing market bubbles usually occur in cities where property investment is prevalent. Numerous factors can determine property prices like the cost of construction, income rates for the area and average monthly rentals.

But sometimes other factors can drive property valuations beyond their worth. For example, when mortgages are granted without adequate collateral, lending institutions become vulnerable to collapse. This is what led to the 2007 US housing market crash and subsequent global recession.

Commodity bubble

Commodity bubbles occur when demand for a particular commodity exceeds its supply, pushing prices higher and higher. These commodity booms often reflect changes in consumer behaviour, particularly in the case of jewellery where prices of certain metals and minerals are determined by their popularity at the time.

Stock market bubble

Stock market bubbles arise when stock prices surge far beyond their real value. The Wall Street crash of 1929 is a good example of a stock market bubble that eventually burst. There are many instances of smaller-scale bubbles which have impacted companies, for example Fitbit, GoPro and Beyond Meat.

Credit bubble

Credit bubbles develop when consumers and businesses are granted credit but without adequate collateral. These loans aren’t secured by expectations of future profits but by future credit. Credit provided in this manner causes a sharp rise in spending but without the ability to repay it.

Causes of speculative bubbles

  1. Displacement: investors get excited by a new product, asset or technology
  2. Price boom: with limited supply and increased demand, prices start to rise quickly
  3. Euphoria: momentum in the market now drives prices even higher
  4. Profit-taking: investors who sense the bubble will soon burst start selling off their positions
  5. Panic: prices fall rapidly as supply exceeds demand, investors are forced to cut their losses

How to trade a speculative bubble

If you want to trade a speculative bubble, you could consider short-selling as it enables you to benefit from falling prices. Trading a speculative bubble in this way is also referred to as ‘going short’ or ‘shorting’.

You can short-sell a variety of markets by using derivative products like CFDs. While these instruments allow you to take advantage of a bubble that has burst, it’s important to remember that prices can change direction at any time. Creating an effective risk management strategy is key to minimising potential losses and protecting profits.

How to start shorting

To start shorting using derivatives, follow these simple steps:

  1. Open an IG trading account: it only takes a few minutes to open an account. You can even do it on your smartphone
  2. Find an opportunity: we offer various tools including the IG market screener, to help you find what you’re looking for
  3. Place your trade: when you’re ready to trade, open your first position by selecting the market you want to short and choosing ‘sell’ on the deal ticket

Ready to start short-selling? Open an account with IG.

Speculative bubbles summed up

  • Speculative bubbles occur when there’s an inflated valuation of an asset due to speculation
  • Financial bubbles can occur in various industries, including the housing and stock markets as well as commodities and credit
  • Excitement over new products or technologies, low interest rates and social pressure all contribute to causing speculative bubbles
  • Traders can benefit from speculative bubbles by shorting a market once its bubble has burst
  • Creating an effective risk management strategy can help mitigate risk and lock in profits

Publication date : 2021-01-22T13:38:59+0000

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