A CFD strategy to hedge losses in a broader portfolio

Tom Welsh
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RECENT falls in the FTSE 100 index, from highs of close to 6,000 in mid-March to its current position under the 5,300 mark, may have spooked some investors. However, it is possible to hedge losses in your equities.

By using contracts for difference (CFDs) as part of a short-term hedging strategy, traders can minimise their losses, or even profit from falls. With proper due diligence, CFD hedges can make your portfolio safer than it would otherwise be.

Brenda Kelly, senior market strategist at CMC Markets, which includes CFD trading among its offering, says that “the ability to hedge an equity portfolio using either an index or an equity trade is one of the key benefits of CFDs.” CFDs allow traders to place bets on the movement of thousands of live markets. They’re relatively short term, fast-paced and, as derivative products, allow gains or losses of more than an initial stake.

Angus Campbell, head of market analysis at London Capital Group, gives the example of an imagined HSBC trade. An investor may own 5,000 shares in the bank “and is worried about them falling in value due to the ongoing Eurozone debt crisis, but still wants to keep them as part of his or her longer term investment strategy.” These HSBC shares might be part of a long-term pension holding, for example.

That investor can, rather than sell the HSBC shares outright, “hedge his or her position by taking out an opposing CFD trade,” essentially betting that the market will move a certain amount in a certain direction. Because CFDs are traded on margin, “you only need a fraction of the total notional value of the trade in your trading account.”

This strategy needn’t be confined to ownership, and concurrent trading, of a single equity. One of the attractions of CFDs is the variety of markets available to traders. As Kelly says, “many investors would own more than one share contained within the FTSE index, so a hedging strategy entailing a short position on the FTSE index itself, during periods of low risk appetite, can help to lock in profits.”

In both these situations, however, the key element is an expected short-term movement. A hedging strategy will only work if you’re confident that, over a short period of time, an equity or an index will shift in one direction or another. CFD trades left open overnight, for example, will result in a charge being levied on your account. If you are seeking to hedge, make sure you bear in mind any of these broader charges.

And similarly, some likely movements will not turn out as expected. It’s therefore crucial to deploy accurate stop-loss orders to prevent a potential hedge against loss from becoming a source of loss in itself. Then again, due diligence should be part of any trading strategy.

There are reasons to use a CFD trade rather than a spread bet. They are, of course, similar products, twin brothers, and often offered in parallel by trading firms. The crucial distinction comes down to tax, and tax will have a bearing on your hedging strategy.

Campbell says that “CFDs are a better product to use for hedging purposes as opposed to financial spread betting because profits from CFDs are taxable.” Therefore, returning to his HSBC example, he says “if you gain from your hedged CFD trade as HSBC’s share price declines, you will not have to pay tax on this profit as you have lost via your underlying investment. Those losses can be offset against the profits of the CFD position.”

However, CFD hedges certainly shouldn’t be used as an excuse to avoid off-loading stock that has little long-term potential. A contorted portfolio, with hedges lined up against equities, and risk built upon risk, could perhaps do with a new look, a fresh pair of eyes.

But, as a means of avoiding, or at least limiting, the harshest consequences of stock market volatility, a creative use of CFDs could be useful. As Campbell says,“It’s an accepted part of a retail investor’s armoury.”

With stock market projections looking less certain than ever, it might be an idea to beef up your portfolio’s protection.