Difference Between Arbitrage and Speculation

Profits are the primary goal of trading in the markets. Traders and investors have devised a variety of financial strategies to make money from market movements. While some strategies have lower risk and provide adequate returns, others are more risky but offer higher returns. Speculation and Arbitrage are two of the most popular financial strategies that traders use. Although arbitrage is often used interchangeably with speculation, there are important differences between the two. Let's dive deeper to understand the differences between speculation and arbitrage.

Arbitrage

Arbitrage refers to the simultaneous purchase and sale of an asset in different markets in order to profit from mismatches in prices. Market inefficiency creates arbitrage opportunities. Arbitrage is common in currency trading and stocks that are listed on more than one exchange. Let's say that the shares of company XYZ were listed on both the Indian Stock Exchange and the New York Stock Exchange. There may be a mismatch between the NSE and NYSE share prices of XYZ due to currency fluctuations. The ideal situation is that the share price of the XYZ stock on the NSE and NYSE should match, taking into account the exchange rate. Stock movements, differences in time zones, and fluctuations in exchange rates can cause temporary mismatches in prices. Arbitrage traders seize the opportunity to buy shares at a lower price on an exchange and then sell them on the exchange that has a higher share price.

Markets are designed to be efficient so arbitrage opportunities can be very brief-lived. Arbitrage opportunities are quickly lost once they have been used. Arbitrage occurs more often in identical instruments but many traders also benefit from a predictable relationship between instruments. A mismatch usually has a very small price. For traders to make sufficient profits from a small price difference, they must place large orders. Arbitrage trades can be executed correctly and are less risky than other types of trading. However, sudden changes in exchange rates or high commissions could make arbitrage opportunities impossible.

Speculation

Every trade is based upon the expectations of the investor. The market functions only when someone is willing buy and someone else is willing to purchase. The seller expects that the price will fall, and so sells to make a profit. However, the buyer expects that the price will rise, and thus enters the counter to earn returns. Speculation can be defined as trading that is based on assumption, expectation or hunch. Speculation involves a lot of risk. Speculation is driven by the possibility of making significant profits. Speculation does not only involve financial instruments, it can also be used to speculate on other assets. Speculation is common in real estate markets, for example. Extreme speculation can lead to asset bubbles such as the dot-com bubble in 2000s or the tulip boom in medieval times. Even small traders can trade on speculation because the profit margins can be very high in speculative trades.

Arbitrage vs speculation

Speculation and arbitrage are two distinct financial strategies. Arbitrage and speculation have major differences in terms of size, duration, risk, and structure. Arbitrage opportunities are only available to large traders. They are often short-lived and have a small profit margin, which means that they require scale. Speculation is not subject to such limitations. Even small traders can make bets on speculation. Arbitrage trades are not as long-lasting, although speculative trades can be made for as little as a few hours to several months. Market inefficiencies create arbitrage opportunities that disappear once someone uses them. Arbitrageurs can simultaneously buy and sell the same asset. Arbitrage trade is risk-free because it allows traders to simultaneously trade. However, speculative trades carry a high risk of losing their capital as the speculative price movements depend on the assumptions of many people.

Conclusion

Speculation and arbitrage are two types of strategies to make money in the financial markets. The main difference between speculation or arbitrage is the fact that the former relies upon natural market inefficiencies, while the latter uses possible price movements for specific assets.