Derivatives - Speculation Vs. Hedging
If you are new to the market, you might have heard the words speculation and hedging many times. Knowing the difference between these two are essential before you start investing in the capital markets. Let us now discuss what these terms mean, the risks involved and how they are different from each other.
Speculation and hedging are both techniques of trading, but are very different from each other from a risk perspective. Hedging is a technique which is mainly used to reduce the market risk in an existing portfolio or trading position that the trader or investor is facing. Speculation, on the other hand is done to earn profits by guessing how the market might be moving in the future.
| Hedging | Speculation |
|---|---|
| Used for Reduce Market Risk | Used for Earn Profit |
Hedging:
Hedging is a risk mitigating strategy, which is useful in volatile market conditions. This is executed by taking an offsetting position to immunize an existing market position that the investor or trader already has. The objective is to have the gains from the hedging position cancel out the losses in the existing portfolio, and not to earn profits.
Let us take an example to understand a practical application of a hedging strategy:
Assume that an investor is having a portfolio of shares of Infosys Ltd. He is afraid that the price of Infosys shares may come down by 5% in the near future.
To hedge the possible loss on the value of his portfolio that he will face if the market comes down, he sells two lots of Infosys futures.
| Date | Particulars | Share Portfolio | Hedge Portfolio |
|---|---|---|---|
| Shares Held | 1000 | ||
| Lot size of Futures | 500 | ||
| 28 October | Market Price (A) | 1100 | 1105 |
| Hedging Strategy | Sell 2 Lots of Infosys Futures | ||
| Value of position held | (1100 x 1000) = 11,00,000 | (1105 x 2 x 500)= 11,05,000 |
So now he has two positions: Long 1000 Shares of Infosys, and Short 2 Lots of Infosys Futures.
His fear about market fall comes true and by 15 November, the price of Infosys Shares crashes by around 5% in both the Equity and Futures Markets. His positions will now be:
| Date | Particulars | Equity Portfolio | Hedged Position |
|---|---|---|---|
| Holding type | Long Equity | Short Futures | |
| Quantity | 1000 shares | 2 lots, i.e. 1000 shares | |
| 15 November | Market Price (B) | 1045.00 | 1046.00 |
| Price Decline (C = B-A) | 55.00 | 59.00 | |
| Profit / (Loss) (C x B) | (55,000) | 59,000 |
Combined Portfolio Position = Rs. (55,000 – 59,000) = profit of Rs 4,000.00
In this way, the smart investor has successfully held this position and offset the loss of Rs. 55,000 that he would have definitely faced if he did not hedge his position.
In this example, we evaluated a situation where the investor was long on a portfolio. Hedging can be also done to protect a portfolio on which the investor is short, e.g. Short Futures and Long Puts, when the market is expected to rise.
There are many techniques of hedging involving assets like Shares, Futures and Options, Commodities and Foreign Exchange. Hedging is done actively by Investors, Derivatives, Forex and Commodity Traders, Exporters and Importers. In fact, Investors and Corporates frequently and actively use hedging strategies to safeguard themselves from possible losses arising due to markets moving against them.
Speculation:
Speculation on the other hand is done to profit from an expected market movement. Here, the traders take a guess about where the market is headed next and trade in that direction. The idea is to earn money from an expected market volatility.
Apart from guessing the next movement in the market, a common strategy adopted by speculators is to calculate whether a stock is overvalued or undervalued and capitalize on the mispricing. If they feel that a stock is overvalued in the market, they will expect the prices to come down. So, they will sell the shares from an intraday trading perspective and wait for the price to come down. They will buy it back once the price comes down, earning a profit. If they expect the decline to happen over several days, they may do the same by Shorting Futures or Buying a Put.
To understand speculation, let us again look at the example we took while understanding hedging. If a speculator feels that the prices of the shares of Infosys might come down by 5%, he will only undertake the second leg of the strategy explained.
He will sell two lots of Infosys futures contracts at Rs. 1105.00 on 28 October and wait for the prices to come down. On 15 November once the price comes down to Rs. 1050, he will square off the position and earn a profit of Rs. 55,000.
A speculator will take a completely opposite strategy if he feels that the stock is undervalued in the market at the moment. He will then buy Shares, Futures or Call options and wait for the prices to rise. Once the price goes up, he will sell his holding to earn a profit.
Risks involved:
Basically, speculators are risk lovers and hedgers are risk averse. Hedgers try to mitigate the risk in a portfolio and safeguard it from uncertainty and volatility in the market. Speculators on the other hand, actively look for market volatility and sharp movements in prices.
Speculation is considered to be extremely risky, since it exposes the speculator to unlimited upsides and downsides in the market leading to large profits as well as losses. So, if you are planning to speculate in the markets, make sure that you have the appetite for large risks.
Hedging is a saviour:
Speculation is for those with a large risk appetite. However, as you might have guessed already, hedging comes to the rescue of everyone, including once in a while for the speculators too. Since they bet on a one-sided movement of the market, a wrong guess can get them into trouble. In such a situation, sometimes they also have to hedge their position to protect themselves from a large loss. Thus, it can be said that hedging is a friend of every market participant.
This article is for education purpose only. Kindly consult with your financial advisor before doing any kind of investment.