#3 – What is the Difference in Arbitrage and Speculation?
Those who dabble in the markets are there to make a profit. Whether they trade alone or work for institutions unless they are a total greenhorn, they follow some tailor-made marketing strategy that performs well for them after a good amount of time, practice, and heaps of patience.
Two different types of financial trading strategies are – Arbitrage and Speculation – and both result in distinct degrees of risk of loss or gain opportunities.
Arbitrage is a popular form of trading and generally with institutional investors and hedge funds. It most often carries a minimal amount of risk. An Arbitrage Strategy most often involves significant security, asset, commodity, etc., which is traded in two separate markets with a pricing difference. The “asset” is bought at a low price then sold for a higher price in another market. This difference in prices yields a profit to the investor. More times than not, this type of trading strategy is used more by the more prominent investors and players.
Arbitrage opportunities occur when a market shows a discrepancy in the price falls lower than it should be due to some carelessness or mismatches in pricing. For the most part, these erroneous prices are short-lived, so taking advantage is essential. (A bit difficult to do if the trader isn’t watching the markets, right?)
Conversely, Speculation doesn’t require a tremendous amount of asset stake and is not likely based on the market forces. Speculation is positioned more on conjecture and could be comprised of any asset in addition to real estate. While the gamble with Arbitrage trading comes with a limited amount of risk, Speculation spurs a greater fortuity of reward or loss.
An Arbitrage is, in essence, a type of hedge since concurrent buys and sells take place and comprise limited risk if done correctly. We should be aware that “limited” doesn’t always mean minor. Such things as the devaluation of a currency and fluctuations in prices could increase the risk, so traders need to keep this in mind to increase the odds of better and higher profitability.
Arbitrage traders ordinarily deal with large amounts since they are pursuing profits from slight pricing variations. Because of these more significant positions, single traders don’t often attempt to engage in Arbitrage trading. You will typically find hedge funds and large corporate investors in Arbitrage trading.
The reward of gain is the driving force behind Speculation trading, although it does carry a considerable risk of loss. But then, if there were no expectation of profit, Speculation would not be a thing. Speculators operate on hunches and assumptions and read the market reports to stay on top of their trades.
Without Speculation, the market would be without liquidity. Traders would be limited to few producers, and the bid-ask spread would widen and make it very hard to find buyers and sellers within a market.
Investing and Speculating are very similar. There are differences, however. If someone were to purchase a house with the intention of the property being his primary dwelling, this would be considered investing. However, if the home was purchased with the intent to sell it quickly for profit, it now becomes Speculation.
Speculation is not confined to any one market or asset. It could include bonds, commodities, currencies, and even derivatives and real estate, as mentioned in the above paragraph.
Speculators in cryptocurrency markets earn from buying low and selling high to turn a profit.
No matter which type of trader you are, the name of the game is profit. This is what keeps us going and growing. Knowing how to trade is paramount to survival in the markets. Knowing and doing can be two different things. It is best for our financial stability to leave some things to the professionals.