Trading and speculating: not the same thing
People use the words interchangeably; the syllabus does not. Trading is short-term activity, over hours, days or weeks, built on price patterns extracted through technical analysis and on the assumption that historical patterns repeat. Speculating is the purchase or sale of an asset in the expectation of gaining from a change in its price over any period, usually short. Speculators act on information they hold, or on their own view of the fundamentals that they expect to move prices.
Both add liquidity to the market. Both typically leverage their buying and selling with borrowed money, which magnifies gains and losses alike. The thin line between them, in the syllabus's phrase, is the probability of gaining or losing: traders have a higher probability of gain than speculators.
The syllabus describes speculators as acting on private or insider information or on their own fundamental view. Acting on unpublished price-sensitive information is prohibited under the insider trading regulations in chapter 14. The description is of what speculators try to do, not a licence.
Hedging: paying to stand still
Hedging is buying an asset or contract to offset losses that could arise on something you already hold. The instruments are the derivatives from the previous topic: forwards and futures, swaps, options. A hedged position is expected to end in no gain and no loss, because a gain on the existing asset is offset by a loss on the hedge, and vice versa. The hedger's motive is not profit; it is the avoidance of loss.
A jeweller holds gold stock worth 2 crore and fears a price fall before the wedding season. She sells gold futures of the same value. Gold falls 10%: her stock loses 20 lakh, her short futures gain about 20 lakh. Gold rises 10%: the stock gains 20 lakh and the futures lose about 20 lakh. Either way she ends roughly where she started, which was the point.
Arbitrage: the same thing at two prices
Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in its price in two markets. Buying a stock in the spot market and at the same moment selling it in the futures market to capture the gap is the syllabus's example.
In an efficient market an arbitrage opportunity lasts only briefly, or never appears. The arbitrageur's own buying pushes up the price in the cheaper market and the selling pushes down the price in the dearer one, until the gap closes and the opportunity is gone.
Buying today because you expect a higher price next month is speculation. Arbitrage requires the buy and the sell to happen together, locking in a price difference that already exists rather than betting on one that might.
Pledging: borrowing against what you own
A pledge is a loan taken against securities. The investor borrowing is the pledgor; the lender is the pledgee. Securities in a depository account can be pledged or hypothecated to obtain a loan or credit facility. When dematerialised securities are pledged they stay in the pledgor's demat account but are blocked, so they cannot be used for any other transaction. Once the obligations under the pledge are met, the securities are unpledged. If the pledgor defaults, the pledgee can take control of the pledged shares and sell them to recover the loan, after giving due notice and a fair chance to repay.
- Trading is short term (hours to weeks) and based on price patterns from technical analysis; speculating seeks gains from price changes over any period based on information or a fundamental view. Traders have a higher probability of gain; both use leverage, which magnifies gains and losses, and both add liquidity.
- Hedging buys an asset or contract to offset potential losses on an existing holding, using forwards, futures, swaps or options; a hedged position expects no gain and no loss, and the hedger is motivated by avoiding loss, not by profit.
- Arbitrage is the simultaneous purchase and sale of an asset to profit from a price discrepancy between two markets; in an efficient market the act of arbitrage closes the gap, so opportunities are brief or absent.
- Pledging is borrowing against securities: the pledgor keeps the shares in the demat account but they are blocked; the pledgee can sell them on default after due notice and a fair chance to repay.