Speculators and hedgers have different terms used to describe traders and investors. Speculation is the attempt to profit from security price change, whereas attempts to hedge to reduce risk and instability associated with security price changes.
Hedging involves taking an offsetting position in a derivative in order to balance the gains and losses of the underlying asset. Hedging attempts to eliminate the variations associated with price of an asset, occupying the position of compensation, 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 the asset will move.
Hedgers reduce their risk exposure by taking an opposite position in the market that they are trying to hedge. The ideal situation in hedging would be to cause one effect to cancel the other.
For example, assume that the company specialiseret in producing jewelry and a big contract for six months, for which gold is one of the main entrances of the company. The company is worried about the volatility in the gold market and believes that gold prices may rise significantly in the near future. In order to protect themselves from this uncertainty, the company may purchase a six-month futures contract on gold. Thus, if gold is experiencing a price increase of 10%, the futures contract will lock in a price that will compensate for this increase.
As you can see, although hedgers are protected from any losses, they are also restricted from any gains. The portfolio is diversified, but is still exposed to systematic risk. Depending on company policy and the type of business he runs, he may choose to hedge against certain business operations to reduce fluctuations in profit and protect yourself from any risks.
To reduce this risk, the investor hedges the portfolio by selling futures contracts on the market and buy options against long positions in your portfolio. On the other hand, if the speculator observes this situation, it may look to short exchange-traded Fund (etf) and futures contract market the potential profit on the downward movement.
Speculators trade on the basis of their guesses about where they think the market is headed. For example, if a speculator believes that a stock is overvalued, he or she can sell the stock and expect the stock price will decline, at which point he or she will buy shares and make a profit. Speculators can suffer to the downside and growth in the market, so speculation can be very risky.
Hedging Is Not Diversification
It is important to note that hedging is not portfolio diversification. Diversification is a portfolio management strategy that investors use to mitigate a risk in one investment, while hedging can reduce losses by selling positions. If the investor wants to reduce their overall risk, he should not invest all your money in one investment. Investors can spread their money on multiple investments to reduce risk.
For example, suppose the investor has $500,000 to invest. The investor can diversify and invest their money in a few stocks in different sectors, real estate and bonds. This method allows you to diversify unsystematic risk; in other words, it protects the investor from the impact of any single event as an investment.
When the investor is worried about a negative decline in the prices of its investments, he may hedge their investments with a substitute position to protect yourself. For example, suppose an investor invested 100 shares in the oil company, XYZ, and believes that the recent fall in oil prices will affect its earnings. The investor does not have sufficient capital to diversify their provisions; on the contrary, he decides to hedge its position by buying options to protect their position. He can buy a put option to protect him from falling stock prices, investors pay a small premium for the option. If XYZ misses her income and the prices will fall, the investor will lose money on his long positions, but to make money on an option which limits the losses.
Overall, hedgers are seen as risk, and speculators generally 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 price fluctuations of securities.