Question:

Can investors/traders use CFDs to protect themselves from market losses on their ordinary share portfolios? And how?

Thomas Roberts, Financial Writer, IG Markets

Answer:

This is an extremely relevant question given the current economic climate.  After all the rate cuts, the Aussie Dollar depreciating in its currency pairs, the continuing Eurozone crisis and worries coming from China, there are sure to be investors out there who may have suffered market losses, or at least have been spooked about the security of their trading portfolio.

One of the advantages things about contracts for difference (CFDs) is their ability to be used as a short-term hedging strategy.  In terms of shares, CFDs allow you to short equities that you may hold in your portfolio; in order to help minimise their losses, or perhaps even profit from their falls.  During times of erratic market volatility and financial uncertainty, such as now, the ability to hedge against long-term investments is what makes CFDs a valuable trading tool.

As an example, let’s say an investor holds shares in BHP Billiton.  With the speculation surrounding the Australian mining industry and demand from China potentially slowing, with HSBC manufacturing PMI estimates indicating that the sector is contracting, an investor may feel that the value of his or her shares could fall in the short-term; however they remain an important part of their portfolio in the long-term.

To cover against this potential short-term loss, rather than sell the shares outright, the investor could take out an opposing CFD trade, in order to hedge their position.  Another reason why this can be appealing to traders is the geared natures of CFDs.  Because of CFDs being geared, traders only need a fraction of the total value of the trade, in order to take a position.  However, due to the geared nature of CFDs the potential loss relative to the initial investment is greater than conventional share trading.

The strategy can also work for investors who hold multiple equities in their portfolio.  In this case, rather than hedge each one individually, an investor may choose to take out a short CFD position on an index with a CFD provider, which reflects the performance of the ASX 200.  The nature of CFDs allows investors to trade the performance of a stock index itself.  Therefore, during times of low-risk and a bearish market sentiment, hedging a share portfolio by shorting indices in this manner, could prove to be an efficient trading strategy.

What this strategy relies on is a definitive move in the market.  May 2012 saw over 350 points be shed from the ASX 200, which most likely constitutes as a conclusive market movement, but investors need to be confident that there will be a significant movement in the market one way or the other before deploying this strategy.  One reason for this is because CFDs are subject to certain charges, such as spreads and overnight positions.  These charges should always be kept in mind when taking out a CFD trade.

In addition, using CFDs as a hedging strategy should not be used as an excuse for not selling equities that have run their course.  Investors should consider carefully whether they should short their equities with a CFD, or simply sell the stock on, which sometimes is the best course of action.  A portfolio that comprises of multiple hedges lined up against multiple equities does not make for a secure equity portfolio and is perhaps one that should be addressed.

However, when executed correctly, hedging with CFDs provides an opportunity to potentially protect an investment against strong short-term volatility.  Given the current economic outlook across the globe, this could be particularly valuable to today’s traders.

Thomas Roberts, financial writer for IG Markets.

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Please consider the Product Disclosure Statement available from IG Markets.  This information does not constitute financial advice and does not have regard to the specific investment objectives, financial situation and needs of any specific person who many receive it.  Consequently any person acting on it does so entirely at his or her own risk.  CFD trading can result in losses that exceed your initial deposit and you do not own or have any interest in the underlying asset.