Contracts for Difference as a Hedging Tool

CFDs also have a valid role as a hedging tool to help investors profit from a falling market. For many investors, the idea of utilising leverage to hedge may seem odd in first light, but with proper understanding of the mechanics and risks of CFDs, CFD hedges can actually make your shareholdings safer than they would otherwise be.

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. Example: selling short a CFD to offset a previous share purchase. 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.

 

Defensive Short Positions

Not many investors utilise CFDs to hedge despite the fact that they are relatively straightforward. However, using short CFDs to hedge your investments is a great way to protect your share portfolio since stock prices are inherently volatile and may move sharply 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. Many CFD investors also have long-only share portfolios and when they are concerned about the volatility or outlook of the general market they can short-sell either particular companies or a broad-based CFD such as the DAX index CFD.

For instance, 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 and selling the shares outright would incur a Capital Gains Tax liability. This would not be the case if the investor had kept holding the shares and hedged the exposure using a CFD although any realised gains on the CFDs in excess of an individual's annual CGT allowance of £10,600 would still be subject to tax (but even in such circumstances there would then be a subsequent reduction in an investor's unrealised gains on the share equity making the CFD hedge worthwhile).

In addition selling your individual share holdings and buying them all back can turn out to be costly. Let's assume the case of a UK investor who has £130,000 invested in equal amounts across 30 different shares. Selling and buying the shares back might cost the investor 10 each way and you have to add the 0.5% stamp duty on top. So 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.

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 crystallise a gain and pay capital gains tax at a particular moment in time and this is certainly a valid strategy. In this case the individual would benefit from offsetting capital gains tax while gaining on the original investment. 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.

Hedge - Single Share: Shorting an Equity via a CFD

A common trading strategy, and a useful one in times of market turmoil makes use of a hedge to protect a single share position with a contract for difference. CFDs are especially useful as a hedging tool because a short position can be replicated to hedge the exact position size required. A short hedge using a CFD is one of the simplest ways to lock in a price by short selling a share to off set the risk of any adverse price movements.

Some hedging tools have standardised sizes and may not move in the same correlation of the underlying stock. This exposes the trader to the risk that the hedge does not fully cover the risk of the position; which risk is commonly referred to as 'basis risk'. CFDs are priced to mirror the market so a neutral market position can be easily created with zero basis risk quickly and cost effectively.

When to get involved -:
  • when the wider market or a particular stock you are invested in is moving against you.
  • when a market position has already moved sharply in the direction of your trade and additional gains may be marginal.
  • when the wider market looks weak and doesn't react to positive or negative news.
When to avoid CFD hedges -:
  • when a trade has moved sharply against you the market is prone to reversing and where hedging near these levels all you would be doing would be locking yourself into a large loss.
  • avoid hedging in general raging bullish markets when everything seems to be going up.
Let's take an example -:

Imagine you hold 10,000 Marks & Spencer shares and you think that their price has had its run but you don't wish to sell your physical stock for capital gain reasons or perhaps even due to the dividend yield. It is September 2010 and with a looming VAT increase, which you believe is likely to result only in some short-term stock weakness, while you believe that Marks & Spencer are still probably a good long-term investment. Originally, you bought the 10,000 Marks & Spencer shares at 227p in July 2008 for a total of £22,700. At the moment, Marks & Spencer is trading at 346p but you expect short-term price weakness due to the VAT increase making merchandise dearer to buy so you decide to hedge your position rather than selling the shares outright.

So you sell an equivalent number of CFDs at the current market price to offset your share investment and create the hedge. That will be 10,000 Marks & Spencer short CFDs at 346p to cover the 10,000 of Marks & Spencer share you own. Given that CFDs are traded on leverage, you only have to pay 10% of the total value of Marks & Spencer shares - at a cost of £3,460 (10,000 x 346 x 10%).

At this point one of the following three scenarios can take place:

Stock price rises - if the stock price of Marks & Spencer were to rise further, you gain on your stock trade but this is offset against the loss on your CFD trade. So for instance if the stock price rallied from 346p to 390p, you would make £4,400 on your share trade but lose £4,400 on your CFD trade. If you believed that the stock price is going to keep rising you would always close the hedge by buying back the CFDs you sold.

Stock price falls - if the stock price of Marks & Spencer were to fall, you gain on your CFD trade but this is offset against the loss on your stock trade. So for instance if the stock price fell from 346p to 300p , you would make £4,600 on your CFD trade but lose £4,600 on your share trade. If you believe that Marks & Spencer will stop falling you , you could close the hedge by buying back the CFDs you sold.

Share price stalls - if the stock price doesn't move, you will neither gain nor lose on either your shares or CFD trade.

This hedge is particularly effective if most of your monies are presently invested in one or two shares. Irrespective of the stock price movements, the hedge allows you to retain any profits from the point at which you employ it.

General or Market Hedge

Another practical way to hedge against your portfolio is to use the CFD index to diversify your investments. Long-term holders of a broad-based share investment portfolio comprising a number of different shares who are worried about the immediate economic outlook can hedge the whole portfolio using index CFDs rather than individual share CFDs.

Instead of selling CFDs in each individual share within the portfolio, an alternative could 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 an index-tracking CFD 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 diversified shares portfolio during the financial crisis of 2008 could have protected his investment by taking a short CFD trade in the FTSE 100. With the FTSE 100 trading at 5,500, and a margin requirement of 1.5% - this would have needed a deposit of 1500 [1.5/100 x 5,500 x 18 contracts] in addition to extra funds to account for any running losses. A number of CFD providers would equal an index CFD to having an exposure equivalent to £1 per point so in this case you would have needed to short about 18 contracts [100,000/5,500]. 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 and the investor would of course also need a few thousand in extra funds to cover any potential losses. 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.

This trading strategy also works in reverse. You may believe that shares in the broader market are set to rise but are unsure which ones to buy. So you buy an index-tracking CFD - based on say the FTSE 100 or S&P 500 one (or indeed you could buy several index tracking CFDs). Now, if shares in general were to rise you would still stand to make money. Whilst a few shares in an index might fall in value, the average performance of the entire index will offset the poor performing equities.

Planning your hedge of course requires some homework - for instance an investor having a portfolio of mining stocks wouldn't be correct to short the FTSE 100 as this wouldn't offer a good hedge. It is also 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.

Limitations

Hedging has considerable advantages. Not only do CFD hedges offer protection against the intricacies of turbulent market conditions but hedging is also a tax efficient mechanism as there is no possibility of incurring a CGT liability, apart from the consequent gain on the CFD. The only cost of an index hedge consists of the bid-offer spread and the small overnight financing fee - and usually there is a credit when shorting although this is not applicable at the current low interest rates. However, it is important to note that although hedging is certainly a valid hedging strategy, the losses on the short FTSE 100 CFD position (building on the above index hedging example) are theoretically unlimited. This shouldn't be a problem as long as the underlying shares portfolio is also rising in value, but if, say, it is full of actively managed funds that can't even keep pace with the index, this may create problems. It is also worth noting that investors will lose part of the benefit of a hedge in a bull market as they will have to keep making margin payments, even though they wouldn't have realised any gains from their standard portfolio or the CFD. Because of this, many professional traders choose to only apply these techniques at crisis points.

 ...Continues here - Trading the News with CFDs

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