Why is hedging important?
Hedging is important because it can help control your exposure to risk. The concept is simple, but even for those who might be familiar with it don’t mind a fresh look at how it works.
Say you’ve added shares of Netflix to your portfolio, and that you’ve purchased ten shares for $200 each. That’s two thousand dollars invested into the streaming giant, and you’re obviously hoping that its sound fundamentals will carry its share price higher.
There’s always that lingering feeling in the background that the investment might go south, and not necessarily due to the company’s fundamentals but say a worsening macroeconomic picture.
Profit and loss on a share investment
For example, let’s say that prices rise from $200 to $250. Your shares investment is now worth $250 X 10 shares = $2,500, resulting in a $500 profit since your initial investment of 10 shares at $200 cost you $2,000.
But if prices drop from $200 to $150, your shares investment is now worth $150 X 10 shares = $1,500, resulting in a $500 loss from the initial $2,000 investment.
Why hedge with CFDs?
A Contract for Difference (CFD) is a financial instrument that will allow you to open a trade in a market correlated to the one you expect to move against you. Referring to the example above, as you approach what could be a rocky couple of quarters, you prefer to limit your risk, only without the need to sell those shares and close out your position. This is where CFDs become useful.
While it may have a fancy name (or not), the concept is simple: it’s a contract that trades on the difference in price without having to own the underlying asset. You could buy and initiate a long position, and if markets move higher, close it out at a profit. But, crucially, the same works in reverse. When markets are dropping, you can initiate a sell position and close it out when prices drop – earning a gain.
Do note that just as when you buy there’s the risk that prices could drop, the same holds true when you initiate a short position and market prices move higher, in both examples effectively going against your trade.
Learn more about short-selling
Trading rising or falling markets with CFDs
As noted, you can use CFDs to trade markets that are rising or falling (decreasing in price). You’d ‘buy’ a CFD when you think a market is going up, or ‘sell’ a CFD (ie going short) when you think it’s going to move lower. This means you can realize gains in markets that are both rising and falling.
In other words, with CFDs, you’re not restricted to making trades where you’d rely on prices rising to earn a profit. This limits potential rewards and risks when it’s a bear market.
Always remember that all trading incurs risk, and that you should only trade amounts of capital you can afford to lose should your prediction turn out to be incorrect.
How to hedge with CFDs
So, how does this pertain to our example above where you’ve invested in ten shares of Netflix and are worried about downside risks? You’ve effectively bought them in the stock market and own the asset, and if you’re concerned prices could drop you can initiate a short position on a CFD on Netflix, holding both at the same time.
You’re ‘long’ in the stock market with ten shares, and you’re ‘short’ in the CFD market with ten shares. So, if prices move up, you’re making money on your stock holding while losing in the CFD market, but if prices go down your CFD position turns green offsetting the red in your portfolio.
Example of hedging with a CFD
Prices rise from $200 to $250, your shares investment is now worth $250 X 10 shares = $2,500 so you’ve made $500, however your shares CFD investment that you shorted at $200 is holding a $500 loss due to the $50 price increasing moving against your CFD sell position on 10 shares ($50 X 100 = $500).
Prices drop from $200 to $150, your shares investment is now worth $150 X 10 shares = $1,500, but because you initiated a short CFD position at $200 and it’s now at $150 means it’s a $50 profit on the 10 CFD shares, $50 X 10 = $500, offsetting the loss from your physical shares investment.
That’s if you decide to be fully hedged, for you can also partially hedge by say shorting only five shares in the CFD market meaning if prices drop, you’d cover half of the losses on your 10 physical shares with the gains from the short CFD position of only five, and if prices rise you’d make money given the gains on the 10 physical shares would be larger than the losses on the five CFD shares.
The example we’ve used was from the stock market, but can be extended to other asset classes like gold for those worried the value of their physical gold could drop by shorting gold CFDs, in the forex market for those looking to convert back to their native currency but are worried FX volatility might derail some of their future plans, and the bond market if you think there’s room for more downside risk when central banks get aggressive.
