The terms Hedging and speculation are used in the Futures contract; both are investment strategies. These are the terms for hedgers and speculators. They play an essential role in the financial market. Hedging is done by hedgers to cover themselves from the associated risk of price fluctuation in the commodity.
At the same time, speculators seek the opportunity of the price change and make money from the variations. Speculators estimate the future price of the stock or commodity and bet based on the current price and make a profit.
We shall see the definition of both Hedging and speculating about understanding the differences between them clearly.
Hedging: is the word used while a trader is trying to manage the risk associated with the price movements. He tries to reduce or eliminate the probability of either profit or loss in the underlying asset price. This can be done by holding two opposite positions in two different markets to balance the potential risk.
Let us understand how a hedge works with a simple example to picture it better.
Let us assume you own a house in a fire-prone area, and you want to protect your home from catching fire. So, what will you do? You might take out fire insurance upon your house (asset).
In this way, you might not control the fire, but you can plan and mitigate the risk when the house catches fire.
Speculating: Speculators are involved in speculating; one of the meanings of these terms is to think. They buy and sell off the asset in the hope of making a profit, but while trading in future contracts, the results can be adverse also; they take advantage of the price fluctuations of the underlying asset.
These underlying assets can be bonds, commodities, currencies, derivatives, stocks, or anything tradable. Speculators are very sharp and clever; they do not randomly jump to a conclusion; instead, they think, calculate and analyze the risk involved and then decide.
Sometimes the investment and speculating process is also considered the same, as both have the same intention to make a profit. Still, when we are talking about speculating, it involves massive amounts, and also quantity is high compared to those who are investing and trading intraday.
We hope you must be clear with the meaning of both the terms hedging and speculating; let us now see the difference between them in a very understandable format.
So, the above table is simple to understand and make a clear mind about the significant difference between them.
The speculation involves attempting to profit from a change in the price of a security. On the other hand, Hedging attempts to reduce the amount of risk or volatility associated with a difference in the price of a security.
Hedging simply means to protect, as in the case of a futures contract. It means protecting your investment from an unexpected drop in prices in the near future. It protects the investor from risk while also limiting the possibility of potential gains.
Speculators always look for opportunities where the chances of profit are relatively high, but there is a significant risk of losing the initial investment. They play an extremely important role in financial market stabilization so that when an everyday investor avoids engaging in a riskier financial transaction, speculators go for it. As a result, they contribute to the economy's liquidity.