The Difference between Speculating and Hedging when Day Trading
Professional traders fall into two categories: speculators and hedgers. Day traders are speculators, but it is important to understand the difference.
Speculators look to make a profit from price changes. Hedgers look to protect against a price change; they make their buy and sell choices as insurance, not as a way to make a profit, so they choose positions that offset their exposure in another market.
As examples of hedging, consider a food-processing company and the farmer who raises or grows the ingredients the company needs. The company may look to hedge against the risks of price increases of key ingredients — like corn, cooking oil, or meat — by buying futures contracts on those ingredients.
That way, if prices do go up, the company’s profits on the contracts help fund the higher prices it has to pay to make its products. If the prices stay the same or go down, the company loses only the price of the contract, which may be a fair tradeoff to the company.
The farmer raising corn, soybeans, or cattle, on the other hand, benefits if prices go up and suffers if they go down. To protect against a price decline, the farmer would sell futures on those commodities. His futures position would make money if the price went down, offsetting the decline on his products. And if the prices went up, he’d lose money on the contracts, but that would be offset by his gain on his harvest.
The commodity markets were intended to help agricultural producers manage risk and find buyers for their products. The stock and bond markets were intended to create an incentive for investors to finance companies. Speculation emerged in all of these markets almost immediately, but it was not their primary purpose.
Day traders are all speculators. They look to make money from the market as they see it now. They manage their risks by carefully allocating their money, using stop and limit orders (which close out positions as soon as predetermined price levels are reached), and closing out at the end of the night.
Day traders don’t manage risk with offsetting positions the way a hedger does. They use other techniques to limit losses, like careful money management and stop and limit orders.
Markets have both hedgers and speculators in them. Knowing that different participants have different profit and loss expectations can help you navigate the turmoil of each day’s trading. And that’s important, because to make money in a zero-sum market, you only make money if someone else loses.