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Every investor aims to maximise returns while minimising risk. However, the dynamics of financial markets present various types of risks that need to be managed. Hedging, speculation, and arbitrage are three common techniques used by investors to capitalise on opportunities or mitigate risks in markets. But what exactly is the difference between these three concepts?
In this article, we will break down the key differences between hedging, speculation, and arbitrage. Read on to gain a deeper perspective on hedging, speculation, and arbitrage in financial markets.
Understanding hedging, speculation, and arbitrage
Hedging, speculation, and arbitrage are all different ways people approach investment and trading.
Hedging is like insurance. It’s a way to protect yourself against potential losses. For example, a farmer might sell a contract to sell their crop for a certain price before it’s even harvested. This way, if the price of their crop goes down, they will retain as much money.
Speculation is when people take big risks to make big profits. It’s like gambling but with investments. Some people might choose to invest in very unpredictable things, like cryptocurrency, because they believe that the price will go up in the future.
Arbitrage is a way to make a profit by buying and selling the same thing in two different markets. For example, if a stock sells for ₹850 in one market and ₹1200 in another, an arbitrage trader might buy the stock in the first market and then sell it in the second market for a quick, risk-free profit.
Key differences between the strategies
1. Objective
There are three potential ways to earn money in the stock market: hedging to decrease risk, speculation to benefit from market movements, and arbitrage to gain from price differences.
2. Risk profile
Hedging is a way to reduce risks by making certain investments that counterbalance each other. Speculation, on the other hand, is when people take bigger risks with the hope of getting bigger rewards. Lastly, arbitrage is when people try to eliminate risks by taking advantage of price differences for the same thing.
3. Liquidity needs
Hedging, speculation, and arbitrage are different ways people invest their money. Hedging is when someone tries to protect themselves from potential financial losses. Speculation is when someone tries to make a lot of money by betting on the market’s direction.
Arbitrage is when someone tries to make money by buying and selling the same asset/stock in different markets simultaneously. Each of these strategies requires different amounts of money and different levels of risk.
4. Holding period
There are various methods to invest in the stock market. One way is called hedging, which involves making choices that are aligned with long-term goals.
Another way is speculation, which involves making bets on the market’s direction in the short term.
A third way is called arbitrage, which involves making quick trades to profit from price differences across different markets.
5. Payoff structure
Hedging, speculation, and arbitrage are three different approaches to investing. Hedging is a way to lower potential losses by giving up some of the potential profit. On the other hand, speculation is when someone takes a bigger risk in the hopes of making a larger profit.
Lastly, arbitrage is a profit-making method by buying and selling assets in different markets, taking advantage of price differences between them. It’s a low-risk strategy that relies on finding temporary price differences.
Illustrative examples
Example 1: hedging with put options
Consider a long-term investor who buys ₹850,000 worth of Infosys shares at ₹1,450 per share. He foresees high short-term volatility in Indian equities. To hedge this downside risk, he could buy put options on Infosys as insurance.
If Infosys falls below ₹1,300 per share before option expiry, the put options become valuable. The gains from the puts offset losses on the stock. So, hedging reduces his net portfolio losses. However, his upside potential also gets capped if Infosys rises significantly beyond ₹1,450.
Example 2: speculating using CFDs
Now, compare this to a speculator who expects Infosys shares to rise in the short run. He wants to bet ₹5 lakh on this price rise compared to his account size of ₹1 lakh. So he buys Infosys contracts-for-difference (CFDs) that provide 5x leverage by allowing 20% margin-based exposure.
If Infosys rises 10% to ₹1,590, his CFD position doubles to ₹10 lakh for a 1,000% profit. But increased leverage also exaggerates his losses. A 10% decline to ₹1,300 would wipe out 50% of his capital despite a correct directional view.
Example 3: arbitraging via futures mispricing
Further, assume the Nifty 50 index trades at 18,100 while the Nifty futures trade at an aberrant 18,300 level owing to a supply glut. An arbitrageur may short-sell overvalued futures while buying the index constituents to lock in ₹200 risk-free profit per lot.
As the futures realign with the spot, the arbitrageur unwinds both legs to pocket the arbitrage spread. By harnessing temporary price distortions, arbitrageurs enhance pricing efficiency. However, this requires continuously scanning markets for potential opportunities.
Pros and cons of each strategy
- Hedging: Offers downside protection but caps profits in exchange. This insulates long-term portfolio positions effectively. However, hedging instruments like options also involve recurring costs. Portfolio balancing is key.
- Speculation: Enables exponential returns if directional bets prove right. However, losses can also multiply if forecasts go wrong. Strict risk control is imperative. Leverage should align with risk appetite.
- Arbitrage: Allows capturing risk-free profits from fleeting opportunities. However, requires sophisticated software for timely execution. Fragmented regulations across global markets pose challenges. Positions still carry some execution risk. Regulatory changes can also impact strategies.
Best practices for using these strategies
1. Define clear objectives – If you are looking to hedge risks, enhance profits or exploit pricing gaps, you need to set goals accordingly.
2. Conduct rigorous research – Develop clear directional views for speculation or identify pricing anomalies before arbitraging.
3. Employ optimal instruments – Use suitable derivatives contracts to hedge or amplify exposures depending on temperament.
4. Control position sizing – Right-size both directional exposures and arbitrage positions within risk limits. Never overextend leverage.
5. Time entries and exits – Enter speculative trades at opportune moments. Exit arbitrage trades before pricing converges fully.
6. Keep an institutional mindset – Follow disciplined stop losses to contain speculative losses. Book arbitrage profits rather than anticipating further upside.
Conclusion
Hedging, speculation, and arbitrage can all play a role in an investor’s toolkit. Hedging aims to give up some profits in exchange for downside risk mitigation. Speculation takes on greater risk in pursuance of exponential rewards. Meanwhile, arbitrage focuses on harnessing short-lived opportunities in different markets with limited to no risk. By understanding the exact difference between these three strategies, investors can deploy them most effectively to meet their specific portfolio objectives.
FAQs
Hedging aims to mitigate risks by taking counter positions, while speculation seeks to magnify returns by deliberately taking on additional risks. A hedging strategy typically sacrifices some upside potential for downside protection, whereas speculation pursues potentially exponential profits at the risk of proportionate losses.
Arbitrage strategies require abundant real-time liquidity across multiple correlated markets to capitalise on short-lived pricing gaps. On the other hand, hedging needs relatively lower liquidity to counterbalance core positions. Meanwhile, speculation pursues above-average liquidity to accommodate the leveraged exposures.
A hedging strategy generally offers a symmetrical payoff where gains from the hedge counterbalance losses from the underlying position, resulting in a smoother risk profile. However, this downside protection comes at the cost of capped profits if the underlying position rises significantly.
By design, speculation relies on leverage, derivatives or concentrated exposures to profit from short-term directional forecasts. While rewards can multiply if proven right, leverage and volatility also exacerbate losses beyond initial capital if markets move adversely.
Arbitrage funds aim to capture fleeting price aberrations that emerge temporarily until the law of one price drives convergence across markets. This necessitates continuously running sophisticated algorithms to identify and instantly execute arbitrage opportunities.