Hedging your portfolio with CFDs

Philip Salter
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IF YOU don’t already, perhaps you should consider hedging your portfolio with contracts for difference (CFD). Provided you have enough time to actively manage your positions and are familiar with their workings, CFDs are worthy of some serious consideration. For many investors, the idea of using leverage to hedge is enough to put them off dabbling in them, but with proper due diligence of the risks, CFD hedges can make your holdings safer than they would otherwise be.

As with spread betting, you can hedge because you are able to place a bet on whether assets are going up or down. Also like spread betting, CFDs are marginal, so you are able to leverage short positions. So for a fraction of the actual cost, you can undertake a hedging strategy. Combined with accurate stop-loss orders to limit potential losses, these are a very useful tool to protect your investments. Hedging does reduce the prospect for striking more profits, but it can make sense to cover your positions. Of course, if you are certain that your portfolio is going sky high, confidence might preclude your desire to hedge your position by shorting against it. If however you are like most investors, you might be looking for a bit of a safer ride, especially given the volatility of the markets over the last few years.

Under what conditions does a CFD hedge make sense? If you think that in the short-term the market is set to drop, but want, or have, to hold onto your portfolio, a hedge against an expected drop in the short-term makes sense. Angus Campbell of Capital Spreads gives a hypothetical example: “if you owned 10,000 shares in HSBC, would like to hold onto them, but fear that a bank levy will have a major impact on the share price, you could hedge yourself to the same amount in a CFD, so any change in the price doesn’t matter.” This example can be mimicked across the asset classes.

According to David Jones of IG Markets “not many investors use CFDs to hedge despite the fact that they are straightforward.” He gives two reasons investors should get into the market. Firstly “if they are expecting a short-term burst of volatility”, but also “for tax reasons”. On the latter point Alastair McCaig of WorldSpreads draws attention to the fact that “CFDs can be used to offset losses incurred against capital gains tax liabilities”. Assuming the other side of the hedge is properly lined-up, the individual will benefit from offsetting capital gains tax while gaining on the original position. Lining up your hedge requires some consideration. Jones makes the point that “if investors have mostly mining stocks sitting in their portfolio, shorting the FTSE 100 is not going to offer your position a decent hedge.”

Given the daily funding charge, in most, if not all instances, CFDs are not a long-term strategy. So when are the best times to get involved? Senior Trader at ETX Capital Manoj Ladwa gives three instances: “when the market or your particular stock turns against you, when a particular position rallies sharply and further upside could be limited, and when the overall market is looking weak, reacting negatively to any kind of news whether positive or negative.”

But there are times to avoid CFD hedges. Ladwa also suggests two scenarios when you should be wary: “when a position has dropped very sharply, the market often snaps back and by hedging near the lows, all you are doing is effectively locking in a large loss”. Also, avoid them “when the market is still showing bullish tendencies. A rising tide lifts all ships – so if the market is going higher, it may be worthwhile holding off from hedging so your portfolio can rise with it”.

For those new to CFDs, there are some technical aspects that you will need to get to grips with before jumping in. Firstly, it should be noted that overleverage is a common mistake for those new to the game. As such it is worth taking sound advice and scouring the readily available sources to find out how much is advisable to put up as a hedge. Another point worth stressing is that although there is no expiry date, the daily funding charge applied to long positions needs to be factored in to your calculations. In most circumstances, these hedges are for the active short-term trader. Finally, it should also be remembered that CFDs are subject to fluctuations in their underlying currency. In volatile times this can add to the complexity of working out the potential costs and profits of the trade.

So with due caution, using CFDs to hedge your position offers protection against the vagaries of volatile market conditions. This only leaves you with the problem of recognising when the conditions are right to hedge, when it is best to leave alone, and when it is best to get out.