Prior to Contracts for Difference rising to popularity, sophisticated traders and investors used to hedge their blue chip portfolio’s using options. When CFDs were launched a whole new area of risk protection opened up and allowed stock market professional and traders everywhere a great deal of control over existing blue chip ASX portfolio’s.
The misinformed public
Misinformed people of the public always have a view that leveraged products and over the counter products are risky but in actual fact, they bring an exciting range of risk protection measures to people’s portfolio’s. No doubt there are traders out there who have lost a lot of money trading CFDs because they used the product incorrectly. On the other hand are hundreds of professional traders and investors who have been able to utilize the product as a great risk protection tool over existing stock market portfolio’s.
How to hedge a $140,000 portfolio
Let’s say you have a $140,000 portfolio of stocks covering the ASX top 20, split up into 7 lots of $20,000. You notice the market marking new high after new high week after week and get a bit nervous and lose faith that the recent incredible run up can continue. Instead of selling your existing share portfolio you may decide to take a direct stock market hedge over each of your holdings.
Breaking down the numbers
Perhaps you are controlling $20,000 worth of Telstra shares and $20,000 worth of BHP shares among your total portfolio. Instead of selling the shares directly into the market you decide to short sell $20,000 worth of CFDs over each of your Telstra and BHP holdings. Your 2 stocks are not perfectly hedged and the margin required to do this would run at around 5-10% of the total $40,000 position. Ie $2,000 to $4,000 would be required to put this CFD hedge in place.
Your prediction came true
Your prediction comes true. The market was overbought and gets sold off heavily. Other investors are crying into their portfolio’s but you are sitting there with poise and emotional control as you know you have a perfectly protected and hedged portfolio. This is where the true power of CFDs come into play. You can hedge your existing portfolio thereby saving you from having to sell your physical share holdings, you get paid every day you are short those stocks and you only require a small fraction of the total position size in margin to control the hedge.
No doubt you can begin to see the power of using Contracts for Difference as a risk management and hedging tool. CFDs don’t have to be a risky tool and always remember its not the product that is risky but the way you use it that counts. No different to a professional butcher using carving knives. Knives can kill in the wrong hands but used properly they can extract the most delicious steak you can imagine.