Hedging is an effective investment mechanism that aims at cancelling or eliminating the risks involved in another form of investment. A hedge is a position opened in one financial instrument with the scope of offsetting exposure to price fluctuations in an opposite position in another asset. The ultimate goal is that of minimising the speculative exposure to unwanted risk. For instance, an investor who holds Next shares might want to open a short CFD position to hedge his long exposure in Next shares. In this way, should the price of Next shares go down, the investor will still not suffer since the losses incurred in the share portfolio will be compensated by the CFD hedge.
Prior to the advent of CFDs, the only way to reduce risk exposure was by using options. A limitation with options is that it only allows multiples of 1000 units; thus, if one has invested in 2460 stocks, he will be able to hedge for 2000 or 3000, using options. Hedging using CFDs, on the other hand, allows for 1 to 1 hedging to account for the risk in equity investments completely.
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Using short CFDs to hedge your investments is a great way to protect your share portfolio since stock prices are volatile and they may move radically up or down, depending on the various market conditions prevalent at that time. In fact CFDs are sometimes used by long-term investors for short-term short-selling opportunities during periods of price correction or short-term pullbacks in the price of shares held within an investment portfolio.
An investor may be holding shares within an investment portfolio with a long-term view that they will continue to rise in price and pay regular dividends. The short-term view may, however, be bearish, or current events may be having a negative impact on share prices of one or more shares within the portfolio. In circumstances like this, the investor may not wish to sell the shares, as the price fall may be only short term.
An investor fearing a market correction can short sell an equivalent amount of CFDs in the same shares, which allows him or her to take advantage of the short-term downtrend trading opportunity. At the same time the investor continues to hold the shares within the investment portfolio. The paper loss on the value of the shares is offset by the profit from the CFD trade if the CFD trade is closed out for a profit.
For example, if a trader holds 2000 shares of a company, he would be able to hedge the risks through CFDs by short selling 2000 shares CFDs to account for the risk exposure for that particular investment in equity.
This strategy is particularly applicable to the larger stocks, which generally have a propensity to rise in value over the long term, yet can be subject to significant short-term pullbacks within the overall long-term uptrend. A number of investors even use this strategy because they don't want to don't want to crystallise a gain and pay capital gains tax at a particular moment in time and this is certainly a valid strategy. Another important aspect of hedging using CFDs is that if you go short, the CFD provider would be liable to paying you on a daily basis for the short position.
Another practical way to hedge against your portfolio is to use the CFD index. Long-term holders of a broad-based share investment portfolio comprising a number of different shares can hedge the whole portfolio using index CFDs rather than individual share CFDs. Instead of selling CFDs of each individual share within the portfolio, an alternative can be to sell CFDs in the main market index. For instance, if you own $150,000 investment in Australian shares as per ASX top 200, as opposed to hedging each and every share individually, you may choose to hedge using the ASX top 200 index. The benefits of hedging, using the index is that the brokerage involved is mostly waived off and the CFD margin are to the tune of 1% only. This means that in effect in order to protect your investment worth $100,000, you need to invest only $1000.
Let's take another scenario. A long-term investor with a £100,000 shares portfolio during the financial crisis of 2008 could have protected his investment by taking a short CFD trade in the FTSE 100. A fall in the value of the investors shares portfolio value would then potentially have been offset by gains in the short FTSE position. In this scenario, the objective would be capital preservation as opposed to speculation. Or, if dealing with a Market Maker CFD provider, use can be made of the synthetic sector indices - such as the banking sector index if the portfolio is heavily weighted towards banks.
It is important to note that a Market Maker offering CFDs on indices will normally cover the position by buying or selling in the corresponding futures market. A spread is then added to the bid/ask prices provided, which will increase the overall cost.
A more transparent option may be simply to deal in the appropriate futures contract and hedge the portfolio on a dollar for dollar basis. Many CFD providers also offer the ability to trade futures through futures trading platforms.
