These players could be categorized into three basic groups:
- Commercial traders (Hedgers)
- Non-commercial traders (Large Speculators)
- Retail traders (Small Speculators)
Don’t Ignore the Commercial Traders
Hedgers or commercial traders are those who want to protect themselves against unexpected price movements.
Agricultural producers or farmers who want to hedge (minimize) their risk in changing commodity prices are part of this group.
Banks or corporations that are looking to protect themselves against sudden price changes in currencies or other assets are also considered commercial traders.
A key characteristic of hedgers is that they are most bullish at market bottoms and most bearish at market tops.
What the hedgehog does this mean?
Example
Here’s a real-life example to illustrate:
There is a virus outbreak in the U.S. that turns people into zombies.
Zombies run amok doing malicious things like grabbing strangers’ iPhones to download fart apps.
It’s total mayhem as people become disoriented and helpless without their beloved iPhones.
This must be stopped now before the nation crumbles into oblivion!
Guns and bullets apparently don’t work on the zombies.
The only way to exterminate them is by chopping their heads off.
Apple sees a “market need” and decides to build a private Samurai army to protect vulnerable iPhone users.
It needs to import samurai swords from Japan.
Tim Cook, the CEO of Apple, contacts a Japanese samurai swordsmith who demands to be paid in Japanese yen when he finishes the swords after three months.
Apple also knows that, if the USD/JPY falls, it will end up paying more yen for the swords.
In order to protect itself, or rather, hedge against currency risk, the firm buys JPY futures.
If USD/JPY falls after three months, the firm’s gain on the futures contract would offset the increased cost of its transaction with the Japanese swordsmith.
On the other hand, if USD/JPY rises after three months, the decrease in the cost of its payment for the samurai swords would offset the firm’s loss on the futures contract.
