When an investor enters the share market, he does so with specific motive in mind. All of them want to make profit but are anxious about its volatility as well. Considering all the players in the stock market to be experts in trading, we can classify them into two groups namely Hedgers and Speculators
Hedging
Hedging in simple terms is like an insurance against any decline in the stock price. It is a way of reducing or diversifying the risk of price fluctuations.
Like in futures, risks can be diversified by pairing the stock owned (long) with a short position. Thus, profits can be made in both long and short positions by reducing the risk of falling stock prices.
For example, an investor buys Bajaj Auto shares (Long) and after sometime foresees a drop in its price. He decides to sell futures (Short) on the stock in order to protect against fall in share price. His futures position would make money if the price of the share went down, offsetting the decline on his actual shares.
Speculating
The price change in shares is what attracts the speculators. They look to make profit from it. Day traders are mostly speculators. For example, an investor buys shares of Videocon Industries after watching the morning news that its price will go up considerably owing to Q2 result announcement with positive reviews. He watches the market movement throughout the day, to find that the share price has gone up by 4%. Before the market closes for the day he sells those shares thereby making a huge profit.
Speculators use stop and limit orders which ends their positions as soon as predetermined price levels are reached.
Future contracts are attractive for speculators as they provide tremendous leverage. Leverage means that instead of paying full price to buy the underlying asset, the same exposure can be taken by paying only a smaller margin amount in the futures. Thus, speculators can take higher exposure of the underlying asset by paying a small margin amount, thereby increasing their profit as well as the risk.
An investor who is bullish on the price of the underlying asset can buy a future contract (Long position) while a person who is bearish would sell the future contract (Short position). But, in these cases, the risk amplifies and therefore one needs to be very careful.
Difference between Hedging and Speculating
Speculation is often confused with Hedging. The operations of both are concerned with unforeseen price change. The former avoids or reduces price risk whereas the latter relies on the price risk.
In hedging, the investor gives up some opportunity of making profit in exchange of reduced price risk.
Whereas, a speculator acquires opportunity in exchange for taking a risk.
There are many reasons why hedging and speculation are often confused. For example, if an investor hedges 50% of his shares and speculates on the other 50%, will he be called a speculator or a hedger? Experts do not have a proper explanation for that. It depends on the risk appetite the investor that decides which category he falls.
