Arbitrage vs. Speculation: An Overview

Investors are always doing what they can to make a profit in the market. After all, isn't that what trading is all about? Whether they are individuals or institutions, investors use a tailor-made financial strategy that works well for them. This strategy only comes after a lot of time, patience, and practice. Arbitrage and speculation are two very different financial strategies, with differing degrees of risk.

Arbitrage is fairly common among institutional investors and hedge funds and comes with a limited amount of risk. This type of strategy involves a large position in a security that is traded in two different markets at different prices. The investor will buy it at a low price on one market and sell it for a slightly higher price on another, thereby profiting off the difference. Because of the nature of this strategy, it's generally not used by small, individual investors.

Speculation, on the other hand, can be. This strategy doesn't need a sizable investment base and may not be based on market forces. It is based on assumptions and can involve any type of security including real estate. While arbitrage comes with a limited amount of risk, speculation does carry a greater chance of reward or loss.

Below, we've outlined some of the key differences between these two financial strategies.

Key Takeaways

  • Arbitrage is a financial strategy that involves the purchase of a security on one market and the sale of the same security for a slightly higher price on another.
  • Speculation is based on assumptions and hunches.
  • Arbitrage involves a limited amount of risk, while the risk of loss and profit is greater with speculation.
  • Anyone can engage in speculation, but arbitrage is mainly used by large, institutional investors and hedge funds.

Arbitrage

Arbitrage involves the simultaneous buying and selling of an asset in order to profit from small differences in price. Arbitrage is possible because of inefficiencies in the market.

Arbitrageurs—those who use arbitrage as a strategy—often buy stock on one market such as a financial market in the U.S. like the New York Stock Exchange (NYSE) while simultaneously selling the same stock on a different market like the London Stock Exchange (LSE). The stock would be traded in U.S. dollars in the United States, while in London, the stock would be traded in pounds. This usually happens very quickly, and once acted upon, the opportunity is gone.

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. Instead, 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. Keep in mind, limited doesn't necessarily mean minor. While there is a chance of losing out from small fluctuations in price, other risks can be much stronger such as the devaluation of a currency. Because arbitrage isn't exactly risk-free, traders need to tailor their situation so the odds of greater profitability increase.

Arbitrageurs typically enter large positions since they are attempting to profit from very small price differences. Because of these large positions, individual investors usually don't engage in arbitrage. Instead, this strategy is used primarily by hedge funds and large, institutional investors.

Speculation

Speculation is a short-term buying and selling strategy. It involves a significant amount of risk of loss or gains. The reward is the main driver, so if there wasn't any expectation of gain, there would be no use for speculation. This strategy is generally driven by assumptions or hunches on the part of the trader, who attempts to profit from rising and falling prices.

Speculation is a very important part of the market. Without it, there would be no liquidity. Participants would be limited to just those producers and companies. This would widen the bid-ask spread, making it harder to find buyers and sellers in the market.

Without speculation, there would be no liquidity in the markets, and market participants would be limited.

Unlike arbitrage, anyone can engage in speculation. You don't need to take large positions in a trade in order to speculate, so anyone can speculate on their trades, from individual investors to large, institutional ones.

There is usually a fine line between investing and speculating. For example, someone may purchase a home as his dwelling. In this case, he may be considered to be investing his money. But if that person purchases a property with the express purpose of selling it quickly for a profit, he is engaging in speculation.

Financial speculation is not limited in the types of securities involved. It can involve the trading of instruments such as bonds, commodities, currencies, and derivatives. It can even be used in the real estate market, as outlined in the example above.

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.