In the world of trading, there are bound to be risks and volatility. Due to the unpredictable nature of financial markets, many traders pick up risk management techniques to help curb and limit their losses. They may also work with more complex instruments such as financial derivatives to execute different trades. From this arises a combination called hedging with CFDs.
To begin with, we’ll define what hedging is as a strategy and what CFDs are. We will then be able to examine how traders can hedge existing positions with CFDs. If you are keen on learning more about this topic to become a better trader, read on.
What is hedging?
Hedging is a strategy that is used to limit losses and risks in financial trading. When traders take a position to hedge, they call the position a hedge. Hedges exist to reduce the risk of adverse price movements of another asset, and therefore, they are always created in relation to another position. Traders may hedge by taking an opposing position in a derivate security, or they may take a new position in a related security. Ultimately, traders use hedges to limit the potential for losses.
What are CFDs?
CFDs, which stand for Contracts for Difference, are financial derivatives. They are legally binding agreements that allow traders to take positions based on their speculation of an asset’s future value. They are a bit like options and futures contracts, in that traders use them to speculate on price movements without owning the underlying asset.
How to hedge with CFDs
Hedging with CFDs can be very effective when done right. Below, we will look at a few strategies depending on the underlying asset.
When traders are dealing in currencies, they can use Forex CFDs to hedge against exchange rate fluctuations by purchasing another currency pair that is tangentially related to the first one. For example, if a trader has bought EUR/USD only to find that the Euro is depreciating but the US dollar continues to strengthen, they can quickly open a hedge and take the position of selling EUR/JPY. This way, they can hedge the losses from the depreciating Euro while keeping their profits from the strong US dollar. (However, naturally, it is crucial for traders to see how the Japanese Yen is faring.)
Another common asset that traders purchase CFDs on is commodities, such as precious metals. Gold, silver, and platinum all share ‘safe haven’ properties that dictate their prices do not fluctuate very much even as the rest of the financial market shakes or inflation increases. If you already own assets related to mining, jewelry, and related companies, you may use gold or silver CFDs to safeguard your investments for short periods of volatility.
Finally, Stock, ETF, and Index CFDs can make effective hedges for instability within the stock market. Traders can categorize trades based on sectors and their performance. They can also turn to baskets of stocks such as ETFs, or track indices, to broaden their exposure and increase diversification within the market. Traders can hold onto these CFDs as hedges as they ride out short-term volatilities while keeping their shares in certain companies over the long term.
Why hedge with CFDs?
Hedging with CFDs can be a very effective way to limit losses for several reasons.
Wide variety of assets
Another advantage of hedging with CFDs is that they are contracts that can be used to speculate on a wide range of assets. From Forex and stocks to commodities and more, a trader can purchase a CFD and take a position in a wide range of markets. This creates flexibility for when traders want to use these contracts as a hedge. The use of CFDs also makes a strong case for portfolio diversification, which can generally lower the risk a trader carries.
Another benefit of hedging with CFDs has to do with flexibility. When traders buy and sell CFD contracts, they can immediately execute and confirm the trade they enter. This is great for traders who are working with rapid market movements and need to establish a hedge to protect their assets quickly. This allows them to lock in a price when they want to.
Traders do not own the asset
As a derivate, CFD traders do not need to physically own the asset they want to speculate on. This is great news, as CFDs will not cause traders any problems when it is time to close their position. They can simply cash out if their hedge is effective, without needing to worry about finding a potential buyer of the assets they now own.
Small initial deposit
Finally, a trader may hedge with a CFD because these contracts are leveraged products. This means that traders can take a position of a certain size by only putting down a fraction of the deposit at the outset. The bank or broker they work with will usually supply the rest.
Risks and limitations of hedging with CFDs
Nevertheless, there are a few risks and limitations that come with hedging with CFDs that all traders should be aware of.
The first risk is obvious and can be applied to all forms of trading. In every trade, there is an inherent risk that lies in market performance. This risk-reward trade-off exists in hedging, as it can subtract from potential earnings. For example, if you think the price movement of an asset will take a downturn and you have a bullish position open, you may be tempted to protect the position with a bearish hedge. Say you do it – and find out there was no market downturn after all. In this case, you would have suffered a loss from the hedge you made.
CFDs cost money
Next, traders should know that CFDs cost money, and therefore, hedging with CFDs is not free. Traders can calculate the price of a CFD based on the market performance of the underlying asset. Namely, based on the difference in price from when one opens their position to when they close it, multiplied by their total position size and any use of leverage. Therefore, traders need to be sure that the losses they curb will exceed. The amount they spend to acquire the hedge in the first place.
Direct correlation with asset price
Finally, the limitation of hedging with CFDs is that these derivatives base their price on the asset’s market performance. This means that regardless of the hedge placed, price movements will correspond only to the asset’s price movements. This can be limiting for some, but it can be remedied by traders simply purchasing a CFD on another asset.
The bottom line
Hedging with CFDs is an effective way to curb losses in times of sudden market volatility. It is also a great tool to keep on one’s belt when there are temporary fluctuations that you want to ride out as a trader. However, all traders would do well to remember that hedging should not replace a good trading plan, and it is important to do thorough research on market development and price patterns before placing a trade. This is so you can lower your own risk in the first place.