Hedging is a strategy that allows you to reduce the risk of adverse price movements by opening an equal opposite position to offset any short term price movements in your physical shares.
Using CFDs to hedge
CFDs offer traders a flexible and cost effective way to offset any short term price movements. The flexibility of using CFDs within your hedging strategies allows you to cost effectively offset any negative short term price movements while:
- Retaining your physical shares and
- Without incurring a CGT liability
CFDs are an ideal hedging instrument due to the their flexibility, the ability to short sell and lower transaction costs.
CFD Hedging Example
Amy holds 1,000 BHP shares purchased in 2006 @ $20.00
The current price of BHP is $45 which represents a profit of $25,000. If the BHP shares were sold Amy would incur a significant capital gain liability.
Amy has strong long term growth projections for BHP therefore she wishes to retain her current BHP shares but there has been significant market volatility especially in the resources sector. Amy wishes to protect her BHP profits from short term volatility while retaining the shares. Amy decides to retain her BHP holdings and open an equivalent short CFD position to protect the value of her BHP shares.
The BHP share price breaks below support levels and Amy decides to short sell 1,000 BHP share CFDs at $45.00 to hedge her physical share position.
In this case study the price of BHP dropped to $42.00. This represents a decline to Amy's BHP share position of $3,000 from $45,000 to $42,000.
However, this loss in value is offset by the gain of $3,029.51 on Amy’s short BHP share CFD position.
Please see the table below outlining the trade.
Trade Example
Sell 1,000 BHP CFDs at $45.00 | $ 45,000CR |
Buy 1,000 BHP CFDs at $42.00 | $ 42,000DR |
Net Profit | $ 3,000CR |
CFD Commission | $ 87.00DR |
Interest received* - 21 days position held open | $ 116.51CR (interest calculated on $45k) |
Gross Profit | $3,029.51CR |
*Interest is calculated at RBA – 2.5% ie 7% - 2.5% = 4.5%. This financing rate is applied to the full value of the position and is applied to the closing price for each day the position is held overnight.
The chart below illustrates the resitance level of $45.00 broken on 5th November and the subsequent levels broken on 25th November.
Risks of employing a Hedging Strategy
- If the price of BHP rose while Amy held the CFD hedge position a loss would have been incurred on the short CFD position.
- Losses incurred on physical shares are only realised when the shares are sold while CFD positions must be meet by cash. Therefore you must ensure you have sufficient cash to fund CFD margins and cover any losses.