Hedging and speculating are the two basic kinds of activities in financial markets. Hedging generally involves trying to reduce risk in order to focus on another subject, while speculating involves taking on risk in order to profit from insight. In general, hedging uses markets in order to avoid worrying about prices, while speculating is based on profiting from price movements.
Hedging and speculating first arose in commodities markets, such as agricultural markets. A farmer, for example, might spend most of the year planting and caring for a crop, but can only sell it after the harvest. If the price drops, the farmer could lose money. Hedging allows the farmer to bet on a price drop, so if prices do drop, the value of the hedge increases.
For nearly as long as there have been hedgers, there have been speculators who would bet directly on price changes. An agricultural speculator might bet that bad weather would hurt a harvest, or that people would eat less of a given food, or even that other speculators would be unreasonably optimistic later on.
Why Hedging Works
Hedging is a profitable activity because it allows hedgers to focus their time and energy on running their business rather than worrying about prices. While price fluctuations can be helpful (for example, a farmer might be the only person unaffected by a drought), they are not predictable. It is not a useful business practice for someone to be at the mercy of factors outside of their control, especially if a business is profitable on average but unprofitable some of the time. Hedging is thus a form of insurance against disaster.
What Speculating Does
While speculators do not reduce risk directly, they do play an important role in markets. A hedger's position is based on the amount of a product that he expects to produce or consume, which does not change often. Thus, a hedger is unlikely to trade frequently, and it is even more unlikely that two hedgers will want to make offsetting trades at the same time. A speculator, by contrast, may change opinions frequently, or may speculate in a variety of different products. Thus, speculators are often on the opposite side of a hedger's transaction. In fact, a speculator can take both sides: an oil speculator might buy from an oil well owner (who is hedging against a drop in oil prices) and then later sell to an airline (who is hedging against a rise in prices).
Harm from Speculation
Speculation can cause harm to other market participants when it causes prices to diverge from reality. If a group of speculators become optimistic about a single commodity, they may drive the price up past a reasonable point. They may be optimistic due to something that has nothing to do with the fundamentals (for example, they may expect other speculators to buy at even higher prices). This high price can harm people who must purchase the commodity, and may lead producers to over-invest.
Rules Governing Speculation and Hedging
Often, laws are more friendly to hedging than to speculation. The purpose of hedging is more apparent, while the value of speculation is harder to see. Thus, some exchanges require more money up front for speculative positions versus hedging positions (a farmer locking in the price of $1,000,000 worth of wheat might need to put up $10,000 to do so; the speculator taking the opposite side of the trade might have to have $50,000 in collateral).