Speculators and hedgers are different terms that describe traders and investors. 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 involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions 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

Hedgers reduce their risk by taking an opposite position in the market to what they are trying to hedge. The ideal situation in hedging would be to cause one effect to cancel out another.

For example, assume that a company specializes in producing jewelry and it has a major contract due in six months, for which gold is one of the company's main inputs. 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.

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 her portfolio by shorting futures contracts on the market and buying put options against the long positions in her portfolio. On the other hand, if a speculator notices this situation, she 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.

Speculation

Speculators trade based on their educated guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he or she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit. Speculators are vulnerable to both the downside and upside of the market; therefore, speculation can be extremely risky.

Hedging Is Not Diversification

It's important to note that hedging is not the same as portfolio diversification. Diversification is a portfolio management strategy that investors use to smooth out specific risk in one investment, while hedging helps to decrease one's losses by taking an offsetting position. If an investor wants to reduce his overall risk, he shouldn't put all his 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 his money into 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 his investment, he can hedge his investment with an offsetting position to protect himself. For example, suppose an investor is invested in 100 shares of stock in an 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 his position; instead, he decides to hedge his position by buying options to protect his position. He can purchase one put option to protect him from a drop in the stock price; the investor pays a small premium for the option. If XYZ misses its earnings estimates and prices fall, the investor will lose money on his long position, but will make money on the put option, which limits losses.

The Bottom Line

Overall, hedgers are seen as risk-averse and speculators are typically 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.