A:

Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions contrary to what the investor currently has. The main purpose of speculation, on the other hand, is to profit from betting on the direction in which an asset will be moving.

Hedgers reduce their risk by taking an opposite position in the market to what they are trying to hedge. The ideal situation in hedging would be to cause one effect to cancel out another. For example, assume that a company specializes in producing jewelry and it has a major contract due in six months, for which gold is one of the company's main inputs. The company is worried about the volatility of the gold market and believes that gold prices may increase substantially in the near future. In order to protect itself from this uncertainty, the company could buy a six-month futures contract in gold. This way, if gold experiences a 10% price increase, the futures contract will lock in a price that will offset this gain. As you can see, although hedgers are protected from any losses, they are also restricted from any gains. Depending on a company's policies and the type of business it runs, it may choose to hedge against certain business operations to reduce fluctuations in its profit and protect itself from any downside risk.

Speculators make bets or guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit. Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky.

Overall, hedgers are seen as risk averse and speculators are typically seen as risk lovers. Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of securities.

RELATED FAQS
  1. What is the difference between speculation and hedging?

    Learn about speculation and hedging, the difference between them, and how traders and investors speculate and hedge. Read Answer >>
  2. Why do companies enter into futures contracts?

    Learn how companies use futures contracts for the purposes of hedging their exposure to price fluctuations as well as for ... Read Answer >>
  3. What is a cross hedge?

    Cross hedging is when you hedge a position by investing in two positively correlated securities or securities that have similar ... Read Answer >>
  4. How are futures used to hedge a position?

    Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between ... Read Answer >>
  5. What happens if you don't hedge your investments?

    Learn the purpose, advantages and disadvantages of hedging, and find out how to utilize hedging to enhance an overall investment ... Read Answer >>
Related Articles
  1. Investing

    Hedging Risk for Beginners: How and When to Do It

    Hedging risk is always a good idea. Here is how sophisticated investors go about it.
  2. Trading

    A Beginner's Guide to Hedging

    Learn how investors use strategies to reduce the impact of negative events on investments.
  3. Trading

    Hedging Basics: What Is a Hedge?

    This strategy is widely misunderstood, but it's not as complicated as you may think.
  4. Investing

    For Maximum Market Returns, Get Creative With Hedges

    Proper hedges help to contain your losses while still allowing profits to grow.
  5. Investing

    A Beginner's Guide To Hedging

    Hedging is a practice every investor should know about.
  6. Investing

    Hedging for Beginners: A Guide

    People hedge as insurance against market volatility. Anyone can do it; here's a primer.
  7. Financial Advisor

    Why Hedge Funds Are Not Living Up to Return Hype

    Hedge funds are supposed to produce better returns while protecting your investments from the downside. Here's why they are not living up to their purpose.
  8. Investing

    Taking A Look Behind Hedge Funds

    Hedge funds can draw returns well above the market average even in a weak economy. Learn about the risks.
  9. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  10. Managing Wealth

    Offset Risk With Options, Futures And Hedge Funds

    Though all portfolios contain some risk, there are ways to lower it. Find out how.
RELATED TERMS
  1. Selling Hedge

    A hedging strategy with which the sale of futures contracts are ...
  2. Hedge Accounting

    A method of accounting where entries for the ownership of a security ...
  3. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  4. Speculation

    The act of trading in an asset, or conducting a financial transaction, ...
  5. Double Hedging

    Hedging a position by using futures and options, thereby doubling ...
  6. Cross Hedge

    The act of hedging ones position by taking an offsetting position ...
Hot Definitions
  1. Asset Turnover Ratio

    The amount of sales generated for every dollar's worth of assets in a year, calculated by dividing sales by assets.
  2. Book Value

    1. The value at which an asset is carried on a balance sheet. To calculate, take the cost of an asset minus the accumulated ...
  3. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends each year relative to its share price.
  4. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. ...
  5. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  6. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
Trading Center