Share prices can be quite volatile and regularly rise and fall. Investors who hold profitable share portfolios inevitably want to protect their profits. Hedging is a popular way to do this.
For example, as a trader you may have an optimistic long-term view on a stock in your portfolio, however in the short term, you may think the share price will track sideways or even fall. When faced with this situation, instead of selling the stock where you may incur a loss, or CGT event, you might choose to protect your position by hedging.
Hedging is a trading technique that enables you to protect your stock portfolio against sudden and unexpected losses. Hedging also affords you increased flexibility to remain in investments when you may otherwise have been forced to exit at a substantial loss. It is up to the individual how many trades they choose to hedge.
A Contract for Difference, or CFD, is an effective instrument to use as part of your hedging strategy. They can be used to help shield an existing share, CFD position or your total portfolio. CFDs are financial derivative instruments that allow you to profit from both rising and falling markets. Since a CFD is a margined product, you can use its leverage to protect the total value of a position whilst only having to outlay from as little as 5% capital.
Why hedge with CFDs
CFDs are an effective hedging tool for the following reasons:
• Low costs
The low margin/deposit requirements and transaction costs associated with CFDs allow you to hedge your share portfolio at a fraction of the cost.
• Most CFDs have no set expiry date
The majority of CFDs have no set expiry so you are not committed to hedge for a fixed term.
• CFDs have low minimum deal sizes
You can open a share CFD position from as little as 1 contract, enabling you to tailor the hedge to your portfolio.
• CFD availability
A huge range of local and international share CFDs are available, plus you can also access indices, forex, commodities and much more.
• Short CFD positions generally earn interest
Most CFD providers will pay you interest on the full value of the short CFD position while it is in place.
How does hedging with CFDs work?
So how does it work? It’s 3 June and you believe the price BHP will fall. To protect your long-term position from a potential loss, you decide to go short by selling 1000 BHP shares as a CFD at $38.00.
On 7 June, you believe the price of your BHP shares are about to resume their recovery. Based on this, you choose to close your CFD position by buying back the CFD at $36.85, giving you a profit of $1.15 per share or $1,150^.
In this example, you have used CFDs to protect your physical position during the fall period (and made a profit), but in the long-term your shares have remained in your portfolio and you can continue to capture any further potential gains.
To learn more about the benefits of CFD trading (Link to: www.igmarkets.co.nz) visit IG Markets, the world’s No.1 CFD provider*.
Trading CFDs may not be suitable for everyone so please make sure you fully understand the risks involved. The Product Disclosure Statement for this product is available from IG Markets – you should consider it before you enter into any transaction with us.
^ This example does not take into account interest, dividends, commission, variation margin and other fees and charges which may apply.
* Largest retail CFD provider by revenue (excluding FX). Source: Published financial statements. As at November 2009.
