Using Index CFDs to Hedge Investment Portfolio


Q.: How do I use an Index CFD to hedge my share portfolio against further downturns?

A: Well, you can either sell your share positions or take out an index CFD. For instance if your portfolio is particularly heavy on blue chip UK stocks, like banking stocks for instance you can hedge against any further downswings by going short on the FTSE 100 CFD contract. Doing this will mean that any further losses on your stocks would be neutralised by the gains on the short index position. Usually the value per index point of one CFD equals one unit of the base currency - pound, dollar or euro . This means that with the FTSE trading at 4,000, an investor who wished to hedge a diversified UK blue chip portfolio worth say, £40,000 would need to short 10 contracts.

 

Q.: If I were to take a short on the FTSE what other trade would you make to hedge against it going up?

A: I rarely hedge that way. I think hedging an Index CFD is nonsense because one can be twice wrong instead of only once wrong! Instead I believe in tight stops.

That said, I suppose it would be OK to hold a long portfolio and hedge against it with a short position but I honestly can't see the point in that either. Just sell your portfolio and make some money from the short.

Q.: I've got 100:1 leverage with my CFD broker (and they offer even higher! 200:1 crazy!!!)


If I long GOOG for example, I only need to use $500 of my margin and if it goes up, you can get another lot for another $500 and increase your positions this way. Of course, the danger is high (more on volatile stocks like GOOG), but I don't know more profitable system than CFDs, even given high spreads it still much profitable than 2:1 ETF. Think like this: with 200:1 leverage you borrow a capital of 1,000,000 with a cost of 5,000, thats 0.005 relation, or if you see it this way: the cost of money is almost 0 because you wouldn't print a dollar physically with a half of a cent or would you?

A: The way to think of CFDs and spreads (CFDs in particular), ironically, is like a mortgage on a house. You put down say 30% (margin in financial services terminology--down payment in real estate terminology). For that money down, you get the upside on 100%. Like with a mortgage, since you are getting 100% exposure for 30% down, you get charged funding charges (a real money maker by the way).

It's all great when your position(s) goes your way. But when they don't, there is a bit of a difference on how mortgages and CFD positions are "foreclosed" as it were. With the mortgage you have a fixed 100% value at the time of purchase, when things may be looking bad, you might have a warning---you lose your job, you read about subprime, etc, and if you know you are stretched, you can sell up and get out.

With CFDs especially since there isn't the stop loss usually, you can go to bed solvent and wake up insolvent.

Who knows what could have happened in after hours trading (if there is on your product). And when the next trading day begins and your position is plummeting, you'd better hope the trader/risk manager is diligently watching your position and closes you out, and you'd better hope that there is no Sept 11 like catastrophe that causes a huge gap, because you could be on the hook for a shedload.

If you are a penny punter then you probably are OK because the company won't waste any time closing you out (so long as you are trading in products with decent liquidity, but that's another issue).

I have also seen clients with large positions in loser products keep begging and cajoling the broker to keep the position open, only to increase ever more the debt. In one instance I know of a trader who left the position open causing the debt to go from what would have been £500K to £1 million.

Now, most small positions you'll be forced closed, but something to keep in mind if you are the kind that gets really carried away. When you pay 100% on a product, you own it and can weather bad times. You don't have that luxury in CFDs/spreads.

Q.: How do I fund my CFDs account?

A: Usually cfd brokers let you fund your account by Cheque/Debit Card/Switch Card/Transfer from your Bank/CHAPS.


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