Speculation is the act of taking on risk with the goal of making money. To understand the use of financial instruments, you must clearly understand the difference between hedging and speculation. Hedgers reduce risk by paying a third party to assume that risk, much like a homeowner pays an insurance company to assume the risk of rebuilding her house in the event of a fire. Speculators, on the other hand, take on risk in the hopes of making money (for instance, if the insurance company takes in more money than it pays out in all of its fire claims, it has speculated successfully on the risk of its customers’ fire losses).
Often, on one side of a financial transaction there is a party attempting to hedge risk. On the other side is a financial services company hoping to profit by taking on the risk of price volatility. This is achieved by charging a fee for the service, building a risk premium into any price guarantee, and/or designing a portfolio of transactions so the financial services company can profit by being a middleman between parties. For instance, if you were going to offer a product guaranteeing price, you might project the expected price level, add in $5/MWh to cover the risk, and add a couple more dollars per MWh for profit. It is critical for both sides of a transaction to carefully track what risk has been assigned to what party and who is hedging versus speculating. Most of the negative stories about use of financial derivatives have occurred because firms were speculating and misjudged the level of risk or because firms thought they were hedging but did not properly understand the level of risk to which they remained exposed.
Speculating may also be used by market participants who think they have a better view of where markets are going than the marketplace as a whole. For instance, if gas futures for next month are priced at $3.00 but a participant’s market view is that they are worth $3.50, she might buy up gas futures with the goal of making money if that view comes true.