How to Hedge With CFD Trading

Oct 06, 2010, 07:58 ET from City Index

LONDON, October 6, 2010 /PRNewswire-FirstCall/ -- For many traders, CFD trading is purely taking a position on the price movements of financial markets. For others, however, CFD trading (http://www.cityindex.co.uk/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 GBP5,000 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.

CFD trading hedge example

If the same investor was to apply CFD trading to their situation, they could 'hedge' their position by short selling Vodafone on a CFD trade. If the buy-sell price was 2500-2500.1p, the investor would go short with a CFD trade of GBP2 per point (GBP5,000 divided by 2500).

From this position, the investor will either make GBP2 for every point that the index falls, thus covering the near-equivalent loss of their portfolio, or they will lose GBP2 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 a CFD trade, the investor retains almost all of the original GBP5,000 value of their portfolio even if the portfolio itself does not. (Example sourced from http://www.cityindex.co.uk).

The only cost incurred by the investor in this hedging process is Capital Gains Tax, 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 Capital Gains Tax (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. You can find more on CFD trading risk management at http://www.cityindex.co.uk/cfd-trading/how-to-manage-risks.aspx.

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 GBPX 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, then your CFD trade 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.

CFD trading carries a high level of risk, but an understanding of it might prove a vital piece of armoury in your investment activity. A CFD trading seminar (http://www.cityindex.co.uk/learn-to-trade/seminars.aspx) could be the ideal place to start.

To learn more about CFD trading and hedging with CFD trades, visit http://www.cityindex.co.uk/cfd-trading/what-is-cfd-trading.aspx.

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 Capital Gains Tax. However, tax laws are subject to change and depend on individual circumstances. Please seek independent advice if necessary.

SOURCE City Index