Hedging vs. Speculation: An Overview
Hedging and speculation refer to strategic activities relating to investing, and speculators and hedgers describe traders and investors of a particular sort. Aside from both being fairly sophisticated strategies, though, speculation and hedging are quite different.
Speculation involves trying to make a profit from a security's price change, whereas hedging attempts to reduce the amount of risk, or volatility, associated with a security's price change.
Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions in it—that is, contrary to what the investor currently has. The main purpose of speculation, on the other hand, is to profit from betting on the direction in which an asset will be moving.
- Hedging and speculation are two types of investment strategies.
- Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions—that is, contrary to positions the investor currently has.
- Speculation concerns attempting to make a profit from a security's price change and is more vulnerable to market fluctuations.
- Hedgers are seen as risk-averse and speculators as risk-lovers.
- Hedging and diversification are different techniques, though both involve counter-balancing and seek to mitigate risk.
Hedging involves taking an offsetting (that is, contrary) position in an investment in order to balance any gains and losses in the underlying asset (the one that backs the derivative). By taking an opposite position, hedgers are trying to protect themselves against no matter what happens, price-move-wise, with the asset—covering all the bases, so to speak.
The ideal situation in hedging would be to cause one effect to cancel out another. It is a risk-neutralizing strategy.
For example, assume that a company specializes in producing jewelry and it has a major order due in six months, one that uses a lot of gold. The company is worried about the volatility of the gold market and believes that gold prices may increase substantially in the near future. In order to protect itself from this uncertainty, the company could buy a six-month futures contract in gold. This way, if gold experiences a 10% price increase, the futures contract will lock in a price that will offset this gain.
Hedging techniques generally involve the use of financial instruments known as derivatives. The two most common derivatives used by investors to hedge are options and futures.
As you can see, although hedgers are protected from any losses, they are also restricted from any gains. The portfolio is diversified but still exposed to systematic risk. Depending on a company's policies and the type of business it runs, it may choose to hedge against certain business operations to reduce fluctuations in its profit and protect itself from any downside risk.
To mitigate this risk, the investor hedges their portfolio by shorting futures contracts on the market and buying put options against the long positions in the portfolio. On the other hand, if a speculator notices this situation, they may look to short an exchange-traded fund (ETF) and a futures contract on the market to make a potential profit on a downside move.
Speculators trade based on their educated guesses on where they believe the market is headed. For example, if a speculator thinks that a stock is overpriced, they may sell short the stock and wait for the price to decline, at which point it can be bought back for a profit.
Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky. But when they win, they can win big—unlike hedgers, who aim more for protection than for profit.
If hedgers can be characterized as risk-averse, speculators can be seen as risk-lovers. Hedgers try to reduce the risks associated with uncertainty, while speculators bet against the movements of the market to try to profit from fluctuations in the price of securities. Both may swim against the tide of market sentiment, but they do so out of very different motives.
It's important to note that hedging is not the same as diversifying your portfolio. Both do involve counterbalancing, it's true.
Diversification is an overall portfolio management strategy that investors use to smooth out risk among all their assets, while hedging helps to decrease one's losses by taking an offsetting position in that specific asset. If an investor wants to reduce their overall risk, they should not put all of their money into one investment. Investors can spread out their money into multiple investments to reduce risk.
For example, suppose an investor has $500,000 to invest. The investor can diversify and put money into different asset classes: multiple stocks in various sectors, real estate, and bonds. This technique helps to diversify unsystematic risk; in other words, it protects the investor from being affected by any individual event in an investment.
When an investor is worried about an adverse price decline in their investment, they can hedge to insure themselves against losses. For example, suppose an investor is invested in 100 shares of stock in oil company XYZ and feels that the recent drop in oil prices will have an adverse effect on its earnings.
The investor does not have enough capital to diversify, so instead, they decide to hedge their position by buying options. The investor can purchase one put option on their shares, which gives them the right to sell the stock for a specific locked-in price (usually, the current one) in the future, paying a small premium for the option. If XYZ misses its earnings estimates and its share prices fall, the investor will lose money on their long position (the stocks they actually own) but will make money on the put option, which becomes more valuable as the price of the underlying stock decreases. If calculated correctly, the two will roughly balance out, so the investor won't be left with too much of a net loss.
Hedging vs. Speculation FAQs
What Does Hedging Mean in Finance?
Hedging is a form of investment insurance. To hedge against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Investors hedge one investment by making a trade in another, or making the opposite move in the same investment—like going short on a stock they own, in case the price drops.
What Is an Example of Hedging?
Let's say you own stock in the Crazy Chocolate Company (their truffles are to die for). You've been hearing how sugar cane crops have been adversely affected by climate change, causing shortages that will make sugar prices soar. This will affect CCC's operations, as they buy a lot of sugar to make their candy, and you fear the stock's going to suffer.
To protect yourself, you hedge by buying a put option on CCC. This option gives you the right to sell the CCC stock at its current price by a certain date in the future. If the stock rises or stays the same, you don't have to do anything. But if the stock falls, you can exercise the option and sell the stock—for the older, higher price you locked in with the option. So this will mitigate the hit you took on the shares dropping.
As an investor, you naturally buy stocks you think will appreciate. But a put option is essentially a bet that share prices will fall. By hedging and buying this option, you were in a sense working against yourself—but you were also covering yourself, and shielding against an overall loss in your investments.
What Is the Difference Between Hedging, Speculation, and Arbitrage?
Hedging, speculation, and arbitrage all are fairly sophisticated, and usually short-term, investment strategies.
Speculation is a trading strategy that often involves very quick-paced buying and selling. It's based on hunches, educated guesses, or theories on price moves—as opposed to fundamentals—about the financial asset or investment. As such, the timing of entry and exit is crucial. Designed to achieve fast profits, speculation involves a significant amount of risk.
Hedging is investing with the intention of reducing the risk of adverse price movements in an asset. A hedge consists of taking an offsetting or opposite position in a security that is the same as, or related to, the one the investor already has. It's a defensive move, designed to limit loss.
Arbitrage is a form of hedging. It also involves making seemingly contradictory investment moves—specifically the simultaneous buying and selling of an asset (or equivalent assets), often in different markets or exchanges, in order to profit from small variations in price. Primarily used by large, institutional investors and hedge funds, arbitrage involves low risk, if executed carefully and precisely.
What Is the Difference Between Hedging and Derivatives?
Hedging and derivatives are actually two different animals. Hedging is an investment technique or strategy. Derivatives are investment instruments—a type of asset class.
The two are related, though, in that hedging strategies—which aim to insure against overall loss—often use certain kinds of derivatives, especially options and futures contracts.