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CFD Hedging Is An Ideal Risk Management Tool

4th May 2016
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CFD Hedging

'Contract For Difference' is the fastest growing financial instrument, which is used by both, veteran and novice investors. CFD is a suitable hedging instrument that assists investors to gain from the falling market.

For many investors, the idea of using CFD hedge as leverage may seem odd at first, but with proper understanding of CFD mechanism and risks, you can actually protect your other financial securities.

When investors buy a specific number of shares, he/she may be worried about protecting his/her investment. Actually, stock prices fluctuate all the time, there is no guarantee if prices will rise, fall, or stay same (as when the investor purchased).

CFD acts as a kind of insurance policy, because it allows investors to enter in an agreement with a 2nd party to exchange, asset value difference [between contract open and close period].

CFD leverage allows investors to protect their total portfolio, without paying a lot of upfront amount. CMC Markets is a popular trading platform that provides assistance to investors, who are interested in CFD hedging.

Risk management strategies applied via CFD hedging

1. Single share or short position -

Hedging single share position and CFD is a popular strategy, when the market is chaotic. It is a simple way to lock in price by selling short.

For example, you hold 10,000 XYZ bank shares, which were initially purchased two years ago at $58,200. The current price of XYZ is between $7.20 and $7.60. Due to some financial issues, the bank can expect considerable short-term fall in prices. You believe that it is a short-term weakness, and the price will eventually turn around and rise upwards.

As there is an uncertainty about market movements, you choose to hedge your position instead of selling out. You choose to trade equal number of CFDs at the existing market price to balance your investment.

You sell 10,000 XYZ CFDs at $7.60. Here CFD is a margin tool, so you enjoy leverage up to 10%.

You pay upfront - 10,000 shares x $7.60/share x 10% = $7,600

If prices rise - If share prices escalate from $7.60 to $8.60, then you will gain $10,000 from share trade, but lose 10,000 on CFD trade. In case, you feel share price will continue rising, then just unwind the hedge, and buy back the sold CFDs.

If prices plummet - If prices drop from $7.60 to $6.60, then you will lose $10,000 on share trade, but gain $10,000 on CFD trade.

Share prices remain same - In case the prices remain unchanged, then there is no profit or loss on either CFD trade or on shares.

2. Trade CFD sectors

If you have a share portfolio, which depends heavily on a specific sector like financial, transportation, energy, health, etc. then you can use CFD for hedging, if you feel that they will underperform or outperform the market.

Your investment gets automatically diversified across several companies with sector CFD trades. Trading a whole sector decreases your exposure to the risks.

3. Index CFDs

With Index CFD, you can speculate the performance of overall stock market and hedge it. It is viewed to be less risky than trading single shares, because the risk is spread across the entire market rather than a single company.

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