Hedging and speculation: possible risks and benefits of financial operations

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In the contemporary era of technical capitalism, the term of speculation is implanted in the brain as something constructively negative and obnoxious. But is the financial speculation really bad? There is no definite answer, or the reader may consider me preposterously naive. To sort it out, we need to understand the meaning of speculation and hedging better. They are essentially different and entail different corollaries and actions.

Ivan Obradovic, the former Customer Success Manager of Semalt, gives the insight on various aspects of financial operations like hedging and speculation, defining what are the pros and cons of running both types of financial risks.

The matter of financial speculation

When you buy or short sale the risky stocks at the market or by making OTC deal and at the same time buy or short sale the stable non-volatile stocks with A+ or higher ranking of high necessity products like milk or toothpaste, which in the recession will have hold position or increase in value, you are hedging. In turn, when you buy or short sale stocks without any subsequent offsetting with saving stocks, you are relying on intuition, buzz and insider information, so, basically, speculating.

Whether financial speculation is good or bad, it is mostly based on whether there are limits for pecuniary arbitrage. If arbitrage is very efficient, markets will be efficient in some relationships which are clear and well understood, but most opportunities for arbitrage are what is called "risk arbitrage". For example, buying an undervalued stock and shorting an overvalued stock in the same industry. These stocks actually differ from each another, and we wouldn't necessarily expect the perfect convergence of price, so we take a risk when we make the imperfect arbitrage.

It's the same way, what people do when they bet on a stock rising to a certain value is because merger or acquisition is closing. The existence of limits for arbitrage mostly revolves around constraints in credit and the possibility that even in a perfect clean arbitrage, the market will move against you in a way that knocks you out from your positions before you can profit from the eventual position of your arbitrage. 

Nevertheless, limits for arbitrage do exist, despite the market can always be moved from an inefficient to an efficient pricing range. We may have reason to believe the market is quite efficient because of the number of the player involved in the trading process and aggregation of information from inside make the picture very effective in theory.

Market's efficiency

Some people say the market is very inefficient because they sit on desks and make prices for their clients through telephones. Seemingly their clients are price takers who don't know where the real price is. When working as a sales manager in Semalt, I have been acting as a price taker, so have got a perfect insight of the blind price assigning. I have learned that people do take what you offer!

However, we know that market efficiency refers to the predictability of price not whether a client is shown a bad price by a market dealer because of some relationship hurdle. It is like if we go into mall stands, we would expect most prices to reflect what you get when you pay that price. You can't profit from that inefficiency because you are a price taker. 

So we can reasonably say the market is efficient, but we may buy things at poor prices though on average, we will buy things at the right prices if we just take prices as given to reflect all information about the products. Same here, we do approach the market efficiency only in case we can speculate with the real price value and understand if the client is price taker or giver!

The difference between hedging and speculation

What is the definite relation between hedger and speculator? Does hedger lose to speculator? I doubt that! The argument related to commodity exchanges and futures speculation is that speculators create liquidity for hedgers and people, who need access to markets at any price at any time. Through constant offers and bids, speculators allow an outlet more economically legitimate use of markets, becoming the counterparty. In other words, for commodity hedging by large corporations, it is like the example Archer Daniel Midlands.

One might think that commodity hedging by these large corporations spills free money into the hands of speculators on these markets, but it is quite the opposite. As hedgers look for the best prices and timing to hedge, it is hedgers who are taking the advantage of speculators, not vice versa. 

You do see speculators occasionally in corner markets making money from games they play with paper futures. Trading in the same way as the trading of physical futures trading with delivery goes, speculation work in most of the illegal activities as it is deeming market manipulation, what can result in loose of license, freezing of accounts and long-lasting litigation.

The paramount idea behind speculation is how you percept the market in a classical or behavioral way, without me mentioning some rumor things, which are pretty controversial. To encapsulate the main idea I want to dig now a bit into the theory. I am more into the Efficient Market Hypothesis of trading or so-called classical finance due to the quick information spread propensity. I do believe that markets are not perfectly efficient same as perfectly inefficient. Thus, we have this conventional concept of technical and fundamental analysis altogether with weakness analysis and data mining with current Internet dominance, what turns to be good for hedging but not for speculation.

Moreover, some exceptions like nullification and size effect are being in contradiction to classical finance, which hence behavioral finance to take over. It is the way you should treat speculative trading. Mental behavior, anchoring, representativeness are all tremendously crucial factors and how the mental shifts affect the investing behaviors and fluctuations on the stock is the way I do observe the speculation!

Where hedging and speculation take roots

Technical analysis is something that seems to work for some people, but I will tell a story that I have heard. Someone made profits from years of trading Cisco and one day he lost a ton of money. Then he looked up the stock and said: "What! Telecommunication equipment!" He had been trading Cisco-like "bloody Sysco" and just basically got totally lucky for years until the news collapse that broke Cisco in the dot-com crash. 

I saw a lot of these examples with speculative risks and audacious hasty one-day investments in Thomson Reuters as an analyst and currently as a financial consultant, but the more I see, the more bizarre the stock market seems to me!

Excessive froth in markets like the stock market is tempered by Federal Reserve rate hikes which harm the ability of people to finance themselves to buy stock. In the 1920s excessive speculation led to a stock market mania, which resulted in a tremendous collapse. In 2007-2008 the same real estate bubbling has made every meager-slug "pro-businessman" own 10 houses and cars only due to risky speculative arbitrage!

Headgears were the ones who preserved the dosh! But here I am pedaling too much of negativity. On the other hand, let's think about what we are doing when we bid up stock prices: we are investing in the economy, speculators are the guys who are creating the liquidity and add the player to the market. So how can that be a bad thing that we make it easier for companies to raise money by issuing stock at higher prices?

So, the excessive purchases of stock isn't a problem. Excessive buying and selling do destroy your returns through transaction costs as soon as you make money not from smart decisions you make with your money, but from the stock market working for you primarily. Runaway stock market mania though is not a sign of overinvestment, it is a sign of poor investment as if even junk bonds (stocks) ride the froth, then something is wrong with the markets. 

When the federal reserve is raising rates it is basically a shift of money from investment in stocks to empowering USA dollar to rise. Thus, people will buy more USA bonds of all types that will make sovereign ceiling move up. Considering that interest rates of many corporate bonds are built on top of government bond interest rates, the government can always confiscate corporate bonds.

So, by speculating you are amassing the pockets of the government and supply USD what, in turn, will lead to debt increase and depreciation of the currency not only in case of the ineffective market. You see, everything is relatively convoluted and speculation can be both good and bad.

Conclusion

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In short, speculation is not the way of making money as soon as it doesn't add economic value. It is more like a clear investment agenda or a strong ability to find arbitrage opportunities that will certainly be rewarded in the bottom line. Speculation may work if one is well informed about the market and has that type of analytical edge when you can to be smarter than the marginal stock market trader, who, in turn, preys on those that have such an edge.

I and my comrades do incline to support the idea that by having a lot of insider information and supporting the behavioral way of financial thinking you may gain much more without losing at all, but it is always worth risking if you are courageous enough and rely on both well-functioning intuition and additional buzz. We recommend buying and holding stocks because even if you lose from the stock market collapse, you will win from being patient – your money will not just grow. It will grow a lot if you needed them back and then, when you don't need them, it will shrink. Generally, it works like the "invisible hand."