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 New York Stock Exchange) 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 U.S. 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 of 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.