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Hedging with CFDs |
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For many traders, CFD trading is purely taking a position on the price movements of financial markets. For others, however, CFD trading is the ideal hedging tool to help protect their investment portfolios.
The principle behind using CFD trading to hedge is one of cost-efficiency. For instance, let us say an investor possesses £5,000 of Vodafone shares. If that investor suspects that the share price might decline over the coming months, they could sell their shares, wait for the value to fall and then repurchase the shares at a cheaper price. The problem with this method is that it can be a costly one, involving 0.5% stamp duty, two lots of dealing commission and potentially Capital Gains Tax (CGT).
CFDs & Hedging Shares
If the same investor was to apply CFD trading to their situation, they could 'hedge' their position by short selling Vodafone on an online CFDs trade.
If the buy-sell price was 2500.0p-2500.1p, the investor would go short with a CFD of £2 per point (£5,000 divided by 2500).
From this position, the investor will either make £2 for every point that the index falls, thus covering the near-equivalent loss of their portfolio, or they will lose £2 for every point that the index rises, a deficit balanced out by the near-equivalent increase in value of the Vodafone shares they own.
In other words, by hedging their bets with CFDs, the investor retains almost all of the original £5,000 value of their portfolio even if the portfolio itself does not.
The only cost incurred by the investor in this hedging process is CGT, meaning that any gain they make from the CFD trading side of the hedge is taxable. Conversely, however, you can use any losses you incur to offset against your CGT liabilities.
With no costs to consider beyond the commission for the opening and closing of each trade and with no spread added to the buy/sell price, hedging via CFD trading is a very attractive proposition.
CFDs & Hedging Forex
CFD trading can also be used to hedge a favourable exchange rate for your holiday via forex.
In this case you would open a CFD trade of £X per point on selling price Y of the relevant currency pair (X multiplied by Y = your predicted spending money).
This creates a balance whereby, if the exchange rate moves up, your CFD makes a loss but you regain the difference through the better exchange rate, and vice versa.
Clearly, this technique will never make you actual profit, but that is not the idea of hedging. The aim is to protect your investment by ensuring that you roughly break even regardless of what the markets do.
Content by City Index.
CFD trading carries a high level of risk, but an understanding of it might prove a vital piece of armoury in your investment activity. Spread betting and CFD trading are leveraged products which can result in losses greater than your initial deposit. Ensure you fully understand the risks.
Spread betting and CFD trading are exempt from UK stamp duty. Spread betting is also exempt from UK CGT. However, tax laws are subject to change and depend on individual circumstances. Please seek independent advice if necessary.
For regular CFD trading news also see: CFDs Blog.
Contracts for Difference (CFDs), margined forex and financial spread trading are leveraged products and may not be suitable for everyone. Losses can exceed your initial deposit. Please ensure that you fully understand the risks involved and seek independent financial advice where necessary.
Hedging with CFDs, last edited by W.Winter, 22-Dec-11.
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Warning: Contracts for Difference (CFDs), margined forex and financial spread trading are leveraged products and may not be suitable for everyone. Losses can exceed your initial deposit. Please ensure that you fully understand the risks involved and seek independent financial advice where necessary.
The contents of this website are for information purposes only and not intended as a recommendation to trade nor does the content constitute investment advice. All reasonable efforts have been made to present accurate information. Neither CFDs-Online.com nor any contributing company or individual accepts any responsibility for any use that may be made of the above or for the correctness or accuracy of the information provided.
* Tax law is subject to change. It can also differ if you pay tax in a jurisdiction other than the UK.
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