Terms like arbitrage and speculation are commonplace words in the market trading lexicon. As a trader in markets, it is essential to understand the arbitrage and speculation differences. The difference is fairly wide since arbitrage is relatively safe while speculation is substantially risky. We look in detail in this segment at the arbitrage and speculation difference.
In the arbitrage vs speculation debate, the most important thing to understand is what do these two terms connote and how are they applied in practice. Why do traders need greater clarity in this arbitrage vs speculation debate so that they can make decisions on capital allocation and risk management in a better way?
Difference Between Arbitrage and Speculation
When trying to analyze the arbitrage vs speculation debate, it is essential to understand that these are two very different financial strategies with varying degrees of risk. For starters, arbitrage is fairly common among institutional investors and hedge funds with access to large amounts of capital but a limited risk appetite. In arbitrage, they buy lower in one market and sell it in another market at a higher price and lock in the spread risk-free.
Speculation is a different ball game altogether. The speculation approach does not need a sizable investment base and may not be entirely based on market forces. Speculation is normally based on news flows but heavily relies on odds. It does not take a very rigorous asset-based approach but instead looks to ride broad trends. The idea is to trade large positions with limited capital and a high-risk appetite. Discipline is the key here.
Getting to the bottom of the arbitrage vs speculation debate
Here is the basic comparison of arbitrage and speculation as market activity.
- Arbitrage is a trading and market strategy that entails the purchase of a security in one market and the sale of the same security for a slightly higher price on another market. The arbitrage locks in risk-free price differential; hence it entails limited risk and needs large volumes to be profitable. On the other hand, speculation is not very capital intensive. However, speculation is based on assumptions and hunches and is not a very scientific approach to value or wealth creation.Speculation is largely based on odds and it is like rotating a slot machine.
- Arbitrage is a low-risk strategy and is normally dominated by institutional players like hedge funds and global arb traders. Arbitrage is based on narrow spreads and hence you need to trade in large volumes to be profitable. On the other hand, speculation can result in higher profits but it can also result in losses as it is based on hunches and estimates and losses can magnify quite rapidly.
- Arbitrageurs rely on predictable and empirically established relationships between asset classes. There are high-risk arbitrage strategies like statistical arbs, but generally, it is a low to medium risk game if played properly and with substantial volumes of capital. Speculation, on the other hand, is based on a bunch of absolutely unpredictable factors that are not only beyond your control but where even risk management is well-nigh impossible in most cases.
- Arbitrage entails synchronized buying and selling of an asset as a result of which it automatically becomes like a hedge position. This entails limited risk when executed properly. There is one risk in international arbitrage you must keep in mind. There are other risks like the devaluation of the currency which can cause a serious risk. Speculation is normally currency-specific, but the asset uncertainty is too high. In speculation, the problem is not a risk but uncertainty.
- Arbitrage is flexible and asset class agnostic. For example, arbitrage can be used between the same asset in different exchanges, between different asset contracts in the same exchange, or between assets that are statistically correlated. Speculation, on the other hand, is more based on assumptions and estimates and does not indulge too much in the scientific approach to trading. Arbitrage is comparatively scientific. Arbitrage is more time-intensive and hence it requires algorithmic execution as well as low latency trading. However, there is no such requirement in the case of speculation.
How to Begin Arbitrage Trading?
The first step to arbitrage trading is to open and activate your equity and account. Normally arbitrage is not possible to be executed manually if you are looking to focus on arbitrage. You can subscribe to one of the arbitrage trading software, which will empower you to place and execute arbitrage trades in the market.
What are the Different Arbitrage Strategies that are Used?
Macro arbitrage is quite popular among arbitrage traders, especially higher-risk players like hedge funds. Here are is a look at types of macro arbitrage strategies.
- Risk arbitrage or Merger Arbitrage is one of the common trades in capital markets. This strategy entails buying stocks that are in the process of a merger or acquisition or amalgamation. Merger arbitrage is popular among hedge funds with a higher risk appetite. They buy the target company’s stocks and short-sell stocks of the acquirer. Such strategies are normally leveraged using futures.
- Retail arbitrage is more of a business-level arbitrage that is done in retail products and products of mass consumption. For example, platforms like Alibaba and Amazon have a plethora of low-cost products that are sourced in China and sold online at a much higher price in different markets where it still makes economic sense.
- Convertible arbitrage is another extremely popular arbitrage strategy. The convertible arbitrage involves buying convertible security like partially convertible debentures or a full convertible debenture and short-selling the underlying stock when there is mispricing visible.
- One of the most popular forms of arbitrage in the modern world is what is popularly referred to as statistical arbitrage. This is an arbitrage technique that entails complex statistical models to decipher trading opportunities across different market prices. Those models are popularly called mean reversion strategies where you bet on prices and trends coming back to normal after significant deviations.
