Hedging your Portfolio through CFDs
Markets have surged this month, recovering from one of the worst August performances for a decade, however they are now trading at key resistance levels with the ASX backing off the top of the trading range that has been in place for the past six months. Because of this market activity, prudent investors may like to take this opportunity to take out some insurance on their portfolio using a hedging strategy.
What is Hedging?
Hedging is a risk management strategy that traders and investors use to limit and/or offset their position from the probability of loss from fluctuations in the prices of their current holdings, this involves taking an equal and opposite position.
Investors may wish to hedge their existing portfolio so that they can still be eligible for the dividends due for the individual parcel(s) of stock, or so that you do not realize the underlying capital gains of the stock portfolio.
The Case for Hedging Your Portfolio
The ASX market has struggled to make a new high this week, for the first time in a month investors are facing some headwinds including: Asian markets being focused on Japan’s expensive currency and China’s commitment to tighten money supply; Europeans refocusing on their sovereign debt problems; the end of the Aussie dividend season; the RBA signaling an interest rate hike, and mixed investor sentiment and economic data from overseas markets.
Overseas data is also pointing to a faltering economic recovery with the US Fed and the Bank of England (BoE) hinting at further quantitative easing, and European investors are spooked again over the sovereign debt concerns which are resurfacing for the PIIGS economies.
Markets look set to avoid the dreaded “double-dip” near-term, but we do expect some weakness into October. We expect the 4650 to 4700 levels to remain at key resistance near-term and because of this suggest that investors should take this opportunity to protect their portfolios as we move close to the seasonally weak month of October.
In this article we will illustrate how you can insure your portfolio by using CFDs to hedge your portfolio position.
Hedge Position Using Index CFD
Hedging involves taking an equal and opposite position to your current portfolio position. Hedging your position using index CFDs means that you can hedge against a fall in the value of your portfolio, if the market does retrace. Please also note that because your portfolio is made up of a limited number of individual share parcels, the change in the value of your share portfolio will not exactly match the movement if the Index CFD. The Australian AU200 Index CFD mirrors the performance of the S&P200 stocks.
Please find below an example:
If you have a $50,000 portfolio of shares and you believe that the Australian share market is set to fall, especially since we are now trading into the seasonally weak October period, you can hedge your portfolio using the Australian AU200 Index CFD, which is currently bid at 4600.0.
This can be achieved by Selling 11 AU200 Index CFDs at 4600.0, which is approximately equivalent to the $50,000 portfolio of stocks, requiring an Initial Margin of 5%, as detailed below.
There are no commissions charged on Index CFDs and as this CFD is trading over an underlying futures contract, there is no funding interest to be applied to the CFD position, as it is already priced in the futures contract.
There are two possible outcomes that can arise from the above example:
1) The market falls:
If the market falls to be offered at 4500.0 by mid-October, then the AU200 Index CFD can be repurchased, to record a profit of $1,100 on the CFD position, even though your portfolio of shares will have devalued by a similar amount.
2) The market rises:
If the market rises by say 100 points to be offered at 4700.0 by the end-of-October, and you feel that the market will continue to rise, then the AU200 Index CFD can be repurchased, to record a loss of $1,100 on the CFD position. However your portfolio of shares will have likely increased in value by a similar amount.
Hedging is all about risk management and traders and investors should consider this strategy if they feel the market is due for a pullback, so as to limit the possibility of loss from the fluctuation in the value of their current holdings.
For more information on CFDs you can contact our CFD trading desk on 1800 853 856 or you can visit our website.
By Michael Hevern
Head of Research
The information provided within this blog is general advice only and you should consult the services of a financial professional in order to ascertain whether the information is applicable to your investment strategies and risk profile.
Be aware that CFDs are leveraged products which carry a high level of risk to your capital, as it is possible to incur losses that exceed your initial investment. Therefore CFDs may not be suitable for your level of acceptable investment risk. Before proceeding with CFD trading, ensure you fully understand the risks involved, otherwise seek independent financial advice.