Forex Hedging
Is Forex Hedging Difficult?
Forex hedging may seem complicated, but it is really a fairly simple concept. In fact, one of the main reasons that the foreign exchange was created was to allow Forex hedging. As world trading grew, people realized there were extra risks involved in trading goods and services between countries, and there had to be a way to minimize this risk.
Why Use Forex Hedging
For example, say that General Motors was going to produce 10,000 cars and ship them to Europe to be sold. They knew that it would take two years to produce this many cars and ship them, and they were afraid that in those two years the dollar might lose its value compared to the European currency. This meant that when General Motors sold its cars to the Europeans in two years, GM might get less money than they would get today. Perhaps they would get even less than it cost to manufacture the cars in the first place.
To keep this from happening, General Motors would buy Eurodollars at today’s rate so that if the US dollar lost value, GM would make up the difference since they already owned European dollars. This is basically what Forex hedging is – reducing your risk by owning currencies on both sides of the trade.
Many traders, especially long-term traders, use Forex hedging often. If a long term trader bought euros with US dollars thinking that the euro would rise, then they would want to protect their investments if the market went the wrong way. To do this, they would buy future contracts that would be profitable if the US dollar went up and the euro went down. Certainly they would not buy equal portions on each side or there would be no point in being in the market. But they may buy future contracts to eliminate 20 to 30% of the risk if the long term trade went against them.
How You Can Profit from Forex Hedging
The beautiful part about Forex hedging tools such as contracts and options is that they can be purchased for just a small percentage of the face value. For example, you might buy a Forex contract for $1, but you would get $10 when that contract expired if the US dollar reached a certain price. If, when that contract expired, the US dollar had not reached that price, you are only out of $1, not $10.
So in a nutshell, that is what Forex hedging is – protecting your investment while still making a profit. People make very good money buying and selling Forex contracts and options, and they do so without paying the entire face value up front.
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