Learn about CFDs - Hedging with CFDs
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Successful traders realise that protecting the money they have is just as important, if not more so, than earning more money from trading. They know that it takes money to make money, and they do whatever it takes to protect their investment capital.
Hedging lets you protect the trades you are in against sudden and unexpected losses, providing the means to remain in investments when you may otherwise have been forced to exit at a loss. Perhaps its greatest benefit is you do not have to hedge every trade, yet you could apply a hedge to almost any trade at any time.
CFDs can be used as part of a hedging strategy to help protect existing positions and your total portfolio. Since a CFD is a margined product its leverage protects the total value of a stock position without you having to pay much up front for it.
In this section we will explain three strategies for hedging individual positions and your entire account:
Hedge - Single Share
One popular strategy, and a useful one in turbulent times, uses a hedge to protect a single stock position with a CFD.
Imagine you currently hold 10,000 Ruritanian Rock Bank shares. It is November 2007 and the bank has problems due to the credit squeeze stemming from difficulties in the U.S. housing market - creating what you believe it is only a short-term weakness, whilst the bank is probably a sound long-term investment.
Initially you bought those 10,000 shares at £5.82 back in November 2005 for a total of £58,200. Currently, Ruritanian Rock is trading between £7.20 and £7.40. But, with the credit crisis looming, you anticipate significant short-term losses, perhaps wiping out all the gains on it to date. However, you expect to see the share price find support and climb again.
Because you don't know if the market will rise or fall, you decide to hedge your position rather than selling out. So you sell an equal number of CFDs at the current market price to offset your stock investment and create the hedge. That will be 10,000 Ruritanian Rock CFDs at £7.40 to cover the 10,000 shares of Ruritanian Rock Bank share you own. Thanks to the leverage you enjoy with CFDs, you must only put up 10 percent of the value of Ruritanian Rock Bank shares - at a cost of £7,400 (10,000 shares × £7.40 per share × 10% = £7,400).
At this point one of the following three things can happen:
Share price rises - if the share price rises, you gain on your share trade but offset that against the loss on your CFD trade. If the share price climbed from £7.40 to £8.40, for example, you would make £10,000 on your share trade but lose £10,000 on your CFD trade. If you believed the share price is going to rise again you could unwind the hedge by buying back the CFDs you sold.
Share price falls - if the share price falls, you gain on your CFD trade but offset that against the loss on your share trade. If the share price dropped from £7.40 to £6.40, for example, you would make £10,000 on your CFD trade but lose £10,000 on your share trade. If you believed the share price is ready to resume its previous trend, you could unwind the hedge by buying back the CFDs you sold.
Share price stalls - if the share price stalls, you will make neither a gain nor loss on either your share or CFD. For example if the share stalled at £7.40 you would make £0 on your share trade but lose £0 on your CFD trade. At this point, if you felt the share price was ready to resume its previous trend, you could unwind the hedge and buy back the CFDs.
Regardless of the share price, the hedge lets you retain any profit from the point at which you employ it.
Pair Trading
Another popular hedging strategy involves buying one company's CFD and simultaneously selling a rival company's CFD. This is called pair trading because you trade a pair of CFDs. The shares of companies in the same industry tend to move in the same direction so, if the industry performs well, most of the shares of the companies within that industry tend to do well too. Of course, the converse is equally true.
As a pair trader, you buy a CFD on the share of the strongest company within the industry and sell a CFD on the share of the weakest company within the industry. Once you have entered your pair trade, you anticipate that one of two things will happen:
- The shares of both companies will rise but the share underlying the CFD you bought will gain more than the share underlying the CFD you sold
- The shares of both companies will lose ground, but the share underlying the CFD you sold will plummet more than the share underlying the CFD you bought.
In both scenarios, you count on losing money on one of your CFDs but expect to make enough on the other CFD to offset your losses and leave a net gain. It is like making a prediction that, if a new Porsche raced a 1961 Volkswagen Beetle, the new Porsche would win. Of course the new Porsche might get a flat tyre or hit a wall before it passed the chequered flag, allowing the humble Beetle to win, but the chances of that happening (unless the Beetle is Herbie) are slim.
Of course both trades could conceivably move in your favor - allowing you to profit from both the CFD you bought as its underlying security moves higher and from the CFD you sold as its underlying security moves lower.
Conversely it is also possible that both trades could end in disaster. You could lose on the CFD you bought as its underlying security moves lower, and likewise lose on the CFD you sold as its underlying security moves higher.
Imagine you wish to pair trade on shares in the oil industry, and you think British Petroleum (BP:xlon) and Royal Dutch Shell (RDSb:xlon) would make great candidates for a pair trade. British Petroleum trades at £5.72 whilst Royal Dutch Shell trades at £20.36.
It is crucial you balance your trade, otherwise it may not perform the way you expect it to. So ensure you control the same amount of value in the assets on which the CFDs are based. In this case you want to control approximately £100,000 worth - or 17,482 shares at £5.72 per share (17,482 × £5.72 = £99,997.04) - of British Petroleum shares and approximately £100,000 worth - or 4,911 shares at £20.36 (4,911 × £20.36 = £99,987.96) - of Royal Dutch Shell shares.
Once you know how many of the underlying shares you want to control, and the current price of those shares, you can enter your trade. Because you are trading CFDs, which employ leverage, you can control £100,000 of the underlying share without using £100,000 of your own money. This time you only have to cover 5 percent of the value of British Petroleum's share price, or £4,999 ( £99,997.04× 5% = £5,000) and 10 percent of Royal Dutch Shell's share price, or £9,999 ( £99,987.96× 10% = £10,000). This means that in total you provide approximately £15,000 in margin to enter this trade with CFDs, not the full £200,000 if you were to use the shares themselves.
Remember that you pay, or receive, interest each day when you trade CFDs on margin. This time you pay interest of £22.80 per day on the British Petroleum CFDs you have bought, yet simultaneously receive interest of £22.80 per day on the Royal Dutch Shell CFDs you have sold. These payments and credits will offset each other in this pair trade.
Now imagine that the price of British Petroleum rises slightly to £5.735 and the price of Royal Dutch Shell falls to £19.52 over the next fortnight, and you exit your trade. Your profit on the British Petroleum position is £0.015 per CFD, or £262.23 (17,482 × £0.015 = £262.23). Your profit on the Royal Dutch Shell position is £0.84 per CFD, or £4,125.24 (4,911 × £0.84 = £4,125.24). Your total profit on this pair trade is therefore £4,387.47 ( £262.23 + £4,125.24= £4,387.47).
Hedge - Index Diversification
Hedging does not necessarily need you to be in two offset positions simultaneously as you do when you hedge a single stock position by offsetting it with a CFD. You can also hedge your overall account risk by diversifying your investments. Whether you expect stocks to rise or fall, you can insure against the unexpected by buying or selling a broad range of CFDs.
The easiest way to hedge by diversifying is to buy an index-tracking CFD, a contract that derives its value from a large stock index like the S&P 500 or the FTSE 100 rather than from a single stock.
You may suspect that stocks in general will rise but be unsure which ones to buy. So you buy a few index-tracking CFDs - the FTSE 100, NASDAQ, S&P 500, Dow Jones and DAX index tracking CFDs . Now if stocks in general increase in value you will make money on your trades. Whilst a few stocks in each index might decrease in value, the average performance of the entire index will counterbalance the poor investments.
This concept also works when you predict that stocks in general will fall. You then sell index-tracking CFDs and benefit from the fall you expected in the overall market.
