Hedging and CFD trading

Anyone owning an existing share portfolio knows how scary things can become if one expects the market to take a substantial dive in the near future – without knowing when and how much it will recover. This is especially true in the case where these shares had recently seen a sharp price increase – that’s when the owner would like to protect these profits at all costs.

Fortunately there is such a way using financial derivatives such as spread trading and CFDs. The latter was in fact developed partly for the purpose of large funds who needed to protect their stock portfolios against price declines.

Due to the particular tax peculiarities of CFDs wheregy gains are subject to CGT (capital gains tax), contracts for difference can also be used as a hedging mechanism against a potential loss in the value of an investor’s shareholding while also helping to offset any losses in CGT liability.

How it works

Take the example of trader John who already owns £100 000 worth of shares in company ABC. He expects these shares to temporarily drop in value over the coming months, but he also expects that the share price will eventually recover, so he does not want to sell the shares at the present moment. The current share price is £100 per share, after it went up nearly 20% over the past few months. John would love to lock in this profit.

The risk profile of this portfolio is illustrated in Fig. 11.01(b) below.

Fig. 11.01(b)

From the above chart it is easy to see that a 10% price decline would bring about a loss of $10 000 for this trader.

The Hedge

Trader John decides to enter into a short transaction in CFDS on Company ABC shares. Since these CFDs are trading at a 10:1 leverage, he only has to deposit an initial amount of 10% of the value of his stock portfolio, i.e. £10 000.

From now on John has ‘locked in’ his profit at the current level. For every £1 the price drops, the short CFDs will gain the same amount in value and for every £1 it increases the CFDs will drop in value.

The risk profile of this combined trade is a flat line, reflecting the fact that it has become unresponsive to price movements.  Fig. 11.01(d) is an illustration of what the new risk profile looks like.

Fig. 11.01(d)

The benefits

Apart from being protected against downward price movements, John’s trading account will also be credited with interest on the short position and it will be debited with any dividends that might be paid during the period he owns the short CFDs. He therefore loses the dividends that could be declared on the original portfolio, but gains interest on the short CFD position.

There are other ways to hedge an existing stock portfolio, e.g. options and futures. Many traders, however, prefer CFDs because:

–      They are cheaper than options. A put option will be significantly more expensive,     although it this has to be weighed against the fact that the put option will still allow the       portfolio to benefit from price increases.

–       They don’t have an expiry date like options. Trader John can protect his portfolio with a short CFD for as long as he wants, while with options he would have to buy new options all the time because they expire.