Hedging and arbitrage both play important roles in finance, economics, and investments. Basically, hedging involves the use of more than one concurrent bet in opposite directions in an attempt to limit the risk of serious investment loss. Meanwhile, arbitrage is the practice of trading a price difference between more than one market for the same good in an attempt to profit from the imbalance.
Each transaction involves two competing types of trades: betting short versus betting long (hedging) and buying versus selling (arbitrage). Both are used by traders who operate in volatile, dynamic market environments. Other than these two similarities, however, they are very different techniques that are used for very different purposes.
When Is Arbitrage Used in Trading?
Arbitrage involves both a purchase and sale within a very short period of time. If a good is being sold for $100 in one market and $108 in another market, a savvy trader could purchase the $100 item and then sell it in the other market for $108. The trader enjoys a risk-free return of eight percent ($8 / $100), minus any transaction, transportation or miscellaneous expenses.
With the proliferation of high-speed data and access to constant price information, arbitrage is much more difficult in financial markets than it used to be. Still, arbitrage opportunities can be found in several types of markets such as forex, bonds, futures and, sometimes, in equities.
When Is Hedging Used in Trading?
Hedging is not the pursuit of risk-free trades. Instead, it is an attempt to reduce known risks while trading. Options contracts, forward contracts, swaps, and derivatives are all used by traders to purchase opposite positions in the market. By betting against both upward and downward movement, the hedger can ensure a certain amount of reduced gain or loss on a trade.
Hedging can take place almost anywhere, but it has become a particularly important aspect of financial markets, business management, and gambling. Much like any other risk/reward trade, hedging results in lower returns for the party involved, but it can offer significant protection against downside risk.