Hedging Using Contracts For Difference

What is hedging?

To quote the dictionary: "A hedge is an investment that has taken out specifically to reduce or cancel out the risk in another investment."

So for this example we will consider that trader X has 2250 BHP shares and would like to hedge their risks by using CFDs. Basically trader X will be looking to short sell 2250 BHP CFDs in order to perfectly hedge their current BHP exposure

A Perfect 1 for 1 Hedge

Prior to CFDs becoming mainstream, the main way for people to hedge their share positions was to use options. One of the limitations of options is the fact that most options are in multiples of 1000 shares which means if you had 2250 BHP shares you could only hedge either 2000 or 3000 shares.

CFDs on the other hand enable you to perfectly hedge one-for-one. So if you had 2250 BHP shares that you could perfectly hedge that exact about using CFDs by shortselling 2250 BHP CFDs.

You get paid to hedge your long positions

One of the interesting aspects of hedging using CFDs is that when you take out an opposing short position using CFDs, the CFD broker will pay you every day you hold the position short. Now you may be asking yourself why anyone would pay you to protect your position and to be honest the answer to that is a little complicated. Suffice to say that every day you hold your position short you earn a small amount of interest. Normally you will earn the overnight cash rate -2% per year calculated back as a daily rate.

You can hedge using a CFD index across the broad index

Another way to hedge your portfolio using CFDs is by using the CFD index. For example you may have a $200,000 portfolio of Australian stocks based on the ASX top 200 and you may wish to hedge that $200 overall position. Instead of hedging each individual stock, you could instead hedge using the Aussie 200 index.

The benefits of hedging using an index CFD are that brokerage is normally free and the CFD margin required may be as little as 1%. This means that in order to control $200,000 worth of a CFD index you would only require $2000 of your own money.

Partially hedging gold stocks

Whilst this strategy is a little more advanced it can be applied by anyone who requires this particular method. In this instance you may have $50,000 worth of Lihir Gold CFDs long and you notice after the 4 PM close on the ASX market that the price of gold is plummeting.

If overnight the price of gold came off say 6-7% then it would not be uncommon for the Gold stocks like Lihir Gold or Newcrest Mining to retreat an equal amount. One alternative to waiting for the ASX market to open the next day is to hedge your $50,000 position by shortselling spot gold CFDs overnight.