Which type of investor are you - hedger, speculator or arbitrageur?

Investors prefer derivatives as they facilitate price discovery, strengthen the underlying asset's liquidity, and work effectively as a hedging tool.

A ‘derivative’ is a financial contract or a security with a price. The value of a derivative contract is determined by the value of the underlying asset. Investors prefer derivatives as they facilitate price discovery, strengthen the underlying asset's liquidity, and work effectively as a hedging tool. There are different market participants in the derivatives markets including hedgers, speculators, and arbitrageurs.   

Hedgers 

A hedge is a position in the market created to protect against potential losses that could be sustained by a companion investment. Stocks, exchange-traded funds, insurance, forward contracts, swaps, options, and derivative products are a few examples of the various financial instruments that can be used to create a hedge. Hedging, therefore, is a risk management strategy used to counterbalance investment losses by holding a contrary position in a related asset. And anyone doing the same is referred to be a hedger. In the derivatives market, hedgers take on the least amount of risk.  

Speculators  

The act of speculating is the buying of a product with the expectation that its value will increase soon. Speculators/traders try to predict future movements in prices of underlying assets. Speculators are very high-risk takers, who only participate in the derivative markets in order to make money. They make a market more liquid, which helps it function efficiently.  

Arbitrageurs  

The practice of buying a security in one market and selling it at a higher price in another market at the same time is known as arbitrage. This allows investors to profit from the momentary difference in cost per share. Investors that seek to take advantage of market inefficiencies are known as arbitrageurs. They serve a crucial economic purpose by closely regulating the pricing of derivatives and their current underlying assets.  

As a result, all three participants in the derivatives market are crucial since their efforts complement one another.