Hedging using CFDs

CFDs provide a way to hedge that’s straightforward and cost effective; replicating the act of buying and selling the shares you’re familiar with while encompassing the concept of leverage that makes options and futures so useful.

The investor using CFDs benefits/suffers to the same extent as the traditional investor but has the advantage of not having to part with the full amount at the outset. He/she also saves on stamp duty as there is no physical purchase. Best of all, the CFD trader can take a positive or negative view.

For example, while traditional Barclays (BARC) shares require the full amount be paid up front (e.g. £10,000 outlay for 5,988 shares at 167p), an identical trade using CFDs involves an initial outlay of just £500 (BARC CFDs require a 5% deposit). The outlay is lower but the risk and reward are the same as if £10,000 of shares were held.

If you’re holding traditional shares – say £10,000 worth of J Sainsbury (SBRY) – and see the market start to come off, then you can take £10,000 worth of short exposure to SBRY using CFDs. You would require a £500 deposit to do so. If the shares fell 20% you would stand to make £2,000, offsetting the loss on your traditional shares (CFD leverage magnifies the return on your small deposit). If the shares gained 20%, however, you would of course be liable for the £2,000 loss, but that would be offset by the profit in your share portfolio.

J Sainsbury (SBRY), daily chart (source: IT Finance, 4 Feb)

Lower dealing costs mean that it’s more cost effective to enter and exit positions multiple times using CFDs which in turn makes them ideal for hedging against short term market volatility. The chart above illustrates just a few instances of heightened volatility in the SBRY share price. We can’t predict the future, so when a major break below support happens, the ability to hedge your portfolio is invaluable. CFDs are flexible enough to allow the investor to hedge short term adverse moves multiple times, bringing relative peace of mind.

For a more detailed rundown of CFDs, their mechanics, associated costs and some trading scenarios click here.