A:

Hedging involves the concurrent use of more than one bet in opposite directions to limit the risk of serious investment loss. 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. These two concepts play important roles in finance, economics and investments.

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.

Arbitrage

Arbitrage involves both 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 8% ($8 / $100), minus any transaction or transportation expenses.

With the proliferation of high-speed computing technology and constant price information, arbitrage is much more difficult in financial markets than it used to be. Still, arbitrage opportunities can be found in the forex market, in bonds, in futures markets and sometimes in equities.

Hedging

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.

RELATED FAQS
  1. How do I use an arbitrage strategy in forex trading?

    See how forex arbitrage acts upon opportunities presented by pricing inefficiencies through the buying and selling of different ... Read Answer >>
  2. What is the difference between arbitrage and speculation?

    Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset ... Read Answer >>
  3. What is the difference between hedging and speculation?

    Hedging and speculation are very different in purpose, function and risk profile. Find out how and why investors use both. Read Answer >>
Related Articles
  1. Investing

    How Statistical Arbitrage Can Lead to Profits

    Find out how statistical arbitrage is leveraged by traders and investors seeking profit by capitalizing on the relationship between price and liquidity.
  2. Trading

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
  3. Investing

    Hedge Funds Hunt for Upside, Regardless of Market

    Hedge funds seek positive absolute returns through aggressive strategies to make this happen.
  4. Investing

    The multiple strategies of hedge funds

    Current and potential hedge fund investors need to understand how much risk hedge funds take on in order to make money.
  5. Trading

    Why Is Arbitrage Trading Legal?

    Not only is arbitrage legal in the US and most developed countries, it can be beneficial to the overall health of a market.
  6. Investing

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. Learn how it works.
  7. Tech

    Looking for Bitcoin Arbitrage Opportunities? Read This First

    Bitcoin arbitrage involves buying relatively undervalued bitcoins and selling them at exchanges where they are relatively overvalued in order to make a profit.
  8. Insights

    How Does Arbitrage Betting Work?

    Arbitrage betting is a method or system for exploiting differences in odds for profit.
  9. Trading

    Massive Hedge Fund Failures

    Flying high one day but not the next - see the stories behind some spectacular meltdowns.
RELATED TERMS
  1. Forex Arbitrage

    Forex arbitrage is the simultaneous purchase and sale of currency ...
  2. Arbitrage

    Arbitrage is the purchase and sale of an asset at the same time ...
  3. Arbitrage Trading Program (ATP)

    An arbitrage trading program (ATP) is a computer program that ...
  4. Index Arbitrage

    Index arbitrage is a trading strategy that attempts to profit ...
  5. Statistical Arbitrage

    Statistical arbitrage is a profit situation arising from pricing ...
  6. Time Arbitrage

    Time arbitrage refers to an opportunity created when a stock ...
Trading Center