Tuesday, March 14, 2006

Hedgers and Speculators

Q:
I was wondering if there was a specific combination of buy/selling a call or put that meant hedging or speculating. In other words, is there some reasoning that if like you buy a put or sell a call is always hedging or does it depend on the person's reasoning for doing what they are doing?

A:
It usually depends on the specific situation. I think the best thing you can do to understand this is to read the solution to the problem on problem set 2 that dealt with this concept. Basically, if you have a number of investments, you need to think about whether they move in the same direction (i.e. you would profit on all or lose on all) or if they are uncorrelated (you will profit on some and lose on others). If it is the first case, one is acting as a speculator, and if it is the second, a hedger. A hedger wants to mitigate risk while a speculator wants to take on risk in hope of a high return.

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