What is the difference between arbitrage and speculation?

By Jean Folger AAA
A:

Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset in order to profit from small differences in price. Often, arbitrageurs buy stock on one market (for example, a financial market in the United States like the NYSE) while simultaneously selling the same stock on a different market (such as the London Stock Exchange). In the United States, the stock would be traded in US dollars, while in London, the stock would be traded in pounds.

As each market for the same stock moves, market inefficiencies, pricing mismatches and even dollar/pound exchange rates can affect the prices temporarily. Arbitrage is not limited to identical instruments; arbitrageurs can also take advantage of predictable relationships between similar financial instruments, such as gold futures and the underlying price of physical gold.

Since arbitrage involves the simultaneous buying and selling of an asset, it is essentially a type of hedge and involves limited risk, when executed properly. Arbitrageurs typically enter large positions since they are attempting to profit from very small differences in price.

Speculation, on the other hand, is a type financial strategy that involves a significant amount of risk. Financial speculation can involve the trading of instruments such as bonds, commodities, currencies and derivatives. Speculators attempt to profit from rising and falling prices. A trader, for example, may open a long (buy) position in a stock index futures contract with the expectation of profiting from rising prices. If the value of the index rises, the trader may close the trade for a profit. Conversely, if the value of the index falls, the trade might be closed for a loss.

Speculators may also attempt to profit from a falling market by shorting (selling short, or simply "selling") the instrument. If prices drop, the position will be profitable. If prices rise, however, the trade may be closed at a loss.

RELATED FAQS

  1. Why does the efficient market hypothesis state that technical analysis is bunk?

    Learn about why there are strong conceptual differences between the efficient market hypothesis and technical analysis about ...
  2. What is the difference between speculation and gambling?

    Learn about speculation and gambling, examples of speculation and gambling, and the main difference between a speculator ...
  3. How do you use a financial calculator to determine present value?

    Learn how to utilize a financial calculator to calculate present value. Understand the necessary data, why it is important ...
  4. What are the most effective ways to reduce moral hazard?

    Discover when moral hazard occurs, what it means in different arenas, and effective tools for lenders, insurers, and employers ...
RELATED TERMS
  1. Discounted Future Earnings

    A method of valuation to estimate the value of a firm.
  2. Altman Z-Score

    The output of a credit-strength test that gauges a publicly traded ...
  3. Maximum Drawdown (MDD)

    The maximum loss from a peak to a trough of a portfolio, before ...
  4. Gross Exposure

    The absolute level of a fund's investments.
  5. Behavioral Modeling

    Using available and relevant consumer and business spending data ...
  6. Yield On Earning Assets

    A financial solvency ratio that compares a financial institution’s ...

You May Also Like

Related Articles
  1. Investing

    Are These 2015's Most-Promising Small-Cap ...

  2. Trading Strategies

    How To Arbitrage Precious Metals

  3. Mutual Funds & ETFs

    A Guide to Using Inverse ETFs for Diversification

  4. Active Trading Fundamentals

    How does the "Buffett Premium" increase ...

  5. Options & Futures

    Applying Binary Options To Equity Markets

Trading Center