How to hedge your portfolio using CFDs
As a trader, you'll no doubt have strategies and preferences in mind when building a personal investment portfolio. It can be driven by an interest in – or knowledge of – a specific industry. Maybe you have a portfolio containing traditional shares? Or perhaps you have a keen eye for markets with attractive spreads and volatility? Whatever your chosen approach, it's worth knowing how to hedge your portfolio to mitigate risk – and how to do that using CFDs.
CFD hedging is a trusted approach used by many traders. It can help maximise the ongoing performance of a portfolio. At the same time, it can protect existing investments and minimise the risks you may face. A CFD hedging strategy can also be deployed at any time. You can use it when trading historically volatile markets. Or it might prove especially valuable in times of uncertainty. Of course, you first need to know how to hedge a portfolio with this approach.
What is portfolio hedging?
Novice, intermediate or expert – no matter your level of trading experience, it's not typically a good idea to put all your investment eggs in one basket. Targeting one specific instrument or market can leave you exposed if things start to move against you. And this can leave you with just one real option to reduce your losses – sell what you own to reduce that exposure.
In such situations, portfolio hedging can prove extremely effective. Your fundamental aim is to mitigate, reduce or eliminate any risks you may be exposed to. It is a technique that means opening a position in one instrument or market to offset any price movement in another where the opposite position is held.
Trading CFDs is one of the best ways to hedge your portfolio because they are flexible and need just a small deposit to execute. If you hold shares in an airline company, for example, you likely hold a long position. If the price of those shares starts to fall, however, you can open a short position using CFDs to offset any losses incurred by that shareholding.
The benefits of hedging with CFDs
Of course, CFDs aren't the only method to consider when thinking about how to hedge currency risk (or otherwise) in a portfolio. You may find that other hedging techniques are more relevant to your needs – such as options or futures. But there is a reason so many investors choose CFDs as their preferred hedging approach. Here are some of the key attributes of CFD hedging.
− You get a linear payoff from CFDs. It means that any rise or fall in an underlying asset translates to an equivalent rise or fall in how much you profit or lose.
− CFDs are versatile derivatives. No matter the market situation, you can take a long or short position to protect against any risk your investments are facing.
− As a product traded on leverage, the amount of capital you need to invest in a trade is just a fraction of its full value. It also means you can move quicker on multiple trades.
− By using a CFD broker like FXCM, there's no shortage of markets for your CFD hedging strategy. Choose from forex, indices, commodities or stocks – it's all available to you.
− Profits made from CFD hedging are taxable – but you won't have to pay tax on a hedged trade because it's made at the expense of a loss on your underlying investment. Nor will you incur tax on shares you may otherwise have sold by not hedging.
How to hedge a portfolio using CFDs
Do you believe CFDs could be the best way to hedge your portfolio? Let's take a look at the practical aspects – and how you might want to go about it. As a general rule, you'll want to take the opposite position to the market exposure you currently have. It can be done in several ways – from focusing on a single stock to hedging the general market to protect a diverse portfolio.
Taking a defensive position
Using CFDs is a short-term approach to offset potential losses on long-held positions. In a lot of cases, this could take the form of shares you physically hold. The difference with CFDs – of course – is that you don't own the underlying asset. One reason portfolio hedging is one to consider is because markets are often volatile. If it's a specific company, the value of its shares can be affected one way or the other by trading results, market conditions or world events.
CFD hedging is, to a degree, about taking a defensive position on your current exposure. Short-selling opportunities offer value and security when a market is under pressure or is undergoing a price correction. It also means that underlying assets do not have to be sold when their value starts to drop. If the belief is that it is a short-term event, a trader can absorb the losses on the long position by hedging with CFDs.
You can, as a trader, look to dispose of shares (or other owned assets) that are falling in value. But this would incur Capital Gains Tax. Once their price moves back in the 'right' direction, you then need to buy back that asset. Stamp duty becomes a consideration with this approach. It's also quite a costly way to trade the market. CFDs, however, will eliminate the cost implications of this – allowing you to retain the asset(s) in the ultimate hope of longer-term gains.
Single share hedging
A CFD hedging strategy can be used to protect a single share position – not least at times when a particular stock or wider market is starting to move against you. It isn't unusual to see this type of approach adopted by traders because CFDs can replicate the size of the position you'll require to offset the risk of a falling price. And this can be done easily and quickly.
CFDs are often priced to reflect the current market, which means it's possible to take a position with zero basis risk.
To give an example, perhaps you hold shares in Boeing and a rise in global oil prices is forecast. Airline stocks are not very receptive to such events, so it's expected the value of Boeing shares will drop. By selling the same number of CFDs as the number of shares you hold, you will hedge that position. And you only have to pay a fraction of that market price to make the trade.
After this point, there are three potential outcomes:
− The first is that Boeing's share price goes up – not down. If so, you'll profit through those shares you already hold. Of course, it does mean you'll incur losses on the CFD trade.
− If Boeing's share price performs as forecast and goes down, a loss is made on the shares you own but is offset by closing out the CFD trade once you believe the price will fall no lower.
− If there's only a nominal impact on Boeing's share price, you gain and lose nothing on either.
One CFD hedging strategy that you may choose to employ is the concept of pair trading. This is based on the notion that share prices for companies in a certain sector are likely to move in the same direction i.e. if one tech company is performing well, others will likely do so too. It also applies to currency pairs with similar attributes, such as those involving the US Dollar.
This strategy isn't necessarily about protecting existing investments, however.
Take the tech sector as an example. A pair trade involves going long on the strongest company while doing the opposite with the weakest. The price of the strongest company should go up higher than the weakest and not fall as low. In all eventualities, one of the CFD trades should at least offset the other. You may even gain (or lose) on both trades at the same time.
For traders with a broader or more diversified portfolio, the best way to hedge a portfolio using CFDs could prove to be general (or market) hedging. Instead of multiple hedges against certain stocks, this portfolio hedging tactic involves index CFDs – such as the DAX or FTSE 100.
This can be a potential solution to mitigate your risk in times when the economic forecast is less promising. One example is Trader A who owns shares to the value of £200,000 in different FTSE 100-listed companies. While it is possible to hedge each shareholding individually, a quicker and more effective strategy is to hedge that portfolio by going short on the index itself.
The deposit needed will be minimal due to the margin requirement involved in trading this index CFD. To protect your overall exposure, the deposit will be no more than £5,000. The UK100 has a minimum value of £0.10p per point with FXCM. By going short on the index, a fall in the value of your total shareholding can be offset.
It is worth noting that additional funds are needed in the event of any losses on the trade.
This is a CFD hedging strategy that can also work in the opposite direction. Specifically, if you're expecting the market to pick up, going long on an index-tracking CFD can result in a gain being made. It means that you don't need to think about which share CFDs (or physical shares) to buy – or any individual assets in your portfolio that fail to perform in line with the improving market.
Things to consider
For all traders, knowing how to hedge your portfolio can make the difference between gains and losses. That said, no investment strategy is ever foolproof. CFD hedging can be an effective way to minimise your risk. But there are no guarantees. CFD trading in itself can result in losses and that applies even when used as a hedging tactic.
To determine if it could be the right approach for your level of exposure, here are some of the main points to consider when portfolio hedging using CFDs:
− As with all forms of CFD trading, the leverage involved can amplify any losses. You will be fully exposed to the market in question – even with a relatively small initial deposit. If you don't take the right position, it could cost you more than you initially put in.
− Hedging a portfolio? When deciding if it is the right approach to take, be sure that any hedge will be matched to your current exposure. The ideal hedge generates gains that will offset losses elsewhere. If this isn't correctly aligned, this won't be the outcome.
− It is unlikely to be the best approach when the market is more settled. The potential to offset the performance of another holding is not as prominent. In a bull market, it may also be that you have to keep making margin payments without achieving any gains.
− There are fees associated with trading CFDs that you need to consider when hedging a portfolio. When trading with a broker, there will be fees to pay for the actual trade e.g. commission. There can also be fees if you hold your CFD position overnight.
− Finally, portfolio hedging should not be used as a technique to retain ownership of stock that has little long-term potential.
Looking to hedge your portfolio?
Is it time to think about your options now you know how to hedge your portfolio? With various factors still affecting global markets, you'll likely want to make sure any existing investments are protected.
As such, there is no time like the present to establish a CFD hedging strategy.
Our dynamic platform gives you the chance to trade price movements in a wide range of stocks, indices, commodities and currencies. As such, we have the instruments you need to devise the hedging strategy that works for you and your investments.
In some cases, we can even provide leverage limits of up to 30:1 when you open a position.
We can offer CFD trading with low fees and 24/5 access to markets. There's no need to wait if the underlying market is closed because there's always an option open to you. You can turn hedging on by logging in and choosing 'Hedging Functionality' from your account settings.
Not yet signed up? Create an FXCM Account now and hedge your portfolio through CFD trading. Our platform has everything you need to succeed with your CFD hedging strategy.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.