Hedging a Portfolio - An Alternative Strategy

In other lessons we have previously discussed trading CFDs for profit and have explained the risk and rewards. Another application is to employ CFDs to hedge positions in your equity portfolio, from one share to a wide selection. Exchange Traded Options (ETO's) are widely used to hedge equity portfolios as well.

Example: Hedging One Share

• You are the proud owner of 20,000 shares in BHP, priced at $36.00.
• You are still bullish and expect the shares will continue to climb in the long term but you anticipate the price to drop a little in the short term.
• Because of Capital Gains Tax reasons (in regard to the time you have held the shares) you don't want to sell the shares. Additionally, you consider them a good long-term investment,
• You want to lock in the gains you've already made, but not sell the shares and therefore create a capital gain.

CFDs are a great tool to do this; you can hedge your portfolio by opening a short CFD position (by selling to open) equivalent to the 20,000 BHP shares in your portfolio, you will be 'market neutral'.

• If the share price of BHP falls $1.00, you will make a compensating gain from your short position on the CFDs.
• If the share price of BHP rises $1.00, you will make a compensating loss from your short position on the CFDs.

Whichever way the price goes, your financial position remains neutral.

As with all hedging there is a cost. In this instance it is the commission you pay to open the CFD position, however, you will receive a net interest payment from the CFD provider as you are shorting the stock. Additionally, there is the indirect cost of depositing a margin payment with your provider to cover the CFD.

Example: Hedging A Large Portfolio of Stocks

If your portfolio contains a diverse range of stocks, the practicality of hedging each stock with a CFD individually may be too much. An alternative would be to hedge an index, for example the S&P/ASX200 (XJO) represents the top 200 listed companies on the ASX.

Assuming you have a share portfolio worth $250,000 that are all included in the S&P/ASX200.

Instead of hedging each company separately, you short the ASX200 (XJO) index. Your CFD provider quotes you 5426/5428, and you sell 46 CFDs at 5426. The value of the contract is therefore $249,596 (assuming each ASX200 CFD is valued at the bid price; $5426) The margin needed will depend upon your individual CFD providers leverage level; i.e. if the leverage level is 1% you will have to commit $2495, for 10% you will have to commit $24,959.

If the value of your individual stocks goes down by 10%, the price of the S&P/ASX200 CFD should also drop by roughly the same amount (depending on which stocks you have and their weighting in the index) and you will make a compensating gain on your CFDs.