Why Traders Use A Forex Hedge:
filed in Forex Hedge on Mar.30, 2010
Before we go on to a discussion of what a forex hedge is, we will briefly review the principles of forex trading and why people get involved in it.
Forex is nothing else but an abbreviation for foreign exchange. We are, in other words, referring to the currency markets here. A forex trader’s job is therefore to buy and sell currencies of other countries. And like any trader selling various other types of products, he hopes that he will generate a profit by doing this.
Not many people will have a problem to comprehend the concept of purchasing a product today and selling it at a profit tomorrow if prices went up in the meantime. This is an age old way of earning a living and people have been doing it for centuries.
Many people, however, find it more difficult to understand how you can make money from something which you don’t yet own at the time of the transaction. This is not as way out as it sounds though. Let us say you have some information indicating that the British Pound is going to drop in price over the next month. All you have to do to make money now is to find a buyer for a certain amount of British Pounds at today’s prices, but delivery should only take place a month from today. At the end of the month you buy Pounds at the new lower prices and hand it to the buyer. He has to pay you the (higher) price you agreed on.
This is called going short on a particular currency. There is another reason why traders do this. Let’s say you already own British Pounds and you are scared the price will drop. You can then do exactly the same as above: Find a buyer at today’s high price, but delivery date is set for some future time. If the price actually drops, you are entitled to still receive today’s price from the buyer, because that is how you agreed. This form of currency trading is referred to as hedging in trading lingo.
The whole concept of a forex hedge is therefore not as complicated as it initially looks. All you are really doing is protecting an existing investment against a potential drop in prices in future.