Whether you are an investor or trader, it is essential to understand the key differences between speculation vs hedging. Hedging allows investors and traders to protect their portfolios against specific risks, while speculation is a speculative investment. The basis for speculative investments is not the same as hedging and therefore it is important to note the differences between the two.
What is speculation?
A speculator will invest or trade based on very little solid information. Call it a hunch, or a strong feeling that a particular asset price will move in a specific direction. This is pretty common in markets, and it is what has made some traders like Jesse Livermore, legendary. Often, those engaged in this type of trades are well aware of the directional movement of asset prices. Therefore, they tend to predict exactly where the price for a particular asset will move in advance. Speculation aims to profit from a directional move of an asset’s price.
To be successful in speculation you need more than just some hunches. In fact, speculation is certainly among the most difficult types of trading approaches, due to the high-risk entailed by such strategies, as well as the uncertainty of the outcome.
What is hedging?
Hedging is something entirely different. Since investors are aware of the risks they face, they need to protect their investment portfolio against such risks. In order to do so, they will first assess the risk associated with their portfolio. The goal of hedging is to protect the portfolio against a specific risk.
Once they realize the risks that might negatively affect their portfolio, they will figure out what type of asset or trade would benefit them if those risks materialize. If they are successful, then they are able to protect their portfolios against such risks. Allowing them to ensure that under the worst circumstances their portfolios will still perform positively. Hedging tries to limit how volatility can affect the portfolio. It is also related to investors who are risk-averse.
What are the key differences between speculation vs hedging?
As we have seen, the differences between hedging vs speculation are vast. Let’s look at some of the most important differences and address them one by one:
- The goals of speculation and hedging are different
- Speculation and hedging have different processes
The goals of speculation and hedging
Since the goal of speculation is to generate a profit, this is a considerable difference from the hedging process. A speculator will often bet on the movement of a particular asset price, while someone hedging its portfolio is only trying to reduce its risk and downside. When we compare the risk profile of an investor engaged in hedging vs speculation we can also see stark differences.
An investor or trader engaged in speculation is looking to take on a considerable amount of risk, and therefore, it has a larger risk appetite and predisposition. On the other hand, someone trying to edge their portfolio is traditionally risk-averse. Therefore, they want to ensure that their portfolio is protected against a particular risk, and against volatility. Both hedgers and speculators have different levels of risk capacity and risk tolerance.
Speculation and hedging have different processes
Since the goals of these two investment strategies are so different, the process by which an investor decides to either speculate or hedge is completely different from one another. Speculation involves picking assets that are likely to have abrupt movements in the short term. While hedging focuses on identifying risks that may negatively affect the portfolio and ensuring the portfolio is protected in case one of these scenarios plays out.
Derivatives in speculation vs hedging
Derivatives play an important role in both speculation and hedging. They are one of the most used financial products for speculation. This is due to the enticing proposition of leverage and the potential payout in case some of the speculative trades prove to be right. On the other hand, they are also extensively used in hedging. Because it allows investors and traders to protect their portfolios in a cost-effective manner. Allowing for the hedging costs to be a small percentage of the total assets under the investor’s control.
Diversification's role in speculation and hedging
Diversification has an important role to play when it comes to hedging vs speculation. It is believed to be one of the only free lunches in finance. However, there are some who argue against it. Stating that a concentrated investment allows you to be exposed to fewer risks, and to a certain extent forces investors to closely monitor fewer positions.
When it comes to speculation, diversification also has an important role to play. Due to the very uncertain nature of this type of trading approach, it is important to keep your bets diversified. In case some of them do not play out the way you expected.
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