CFDs can be used as a hedging strategy to help protect existing positions.
CFD hedging strategy #1 - single share
This strategy combines share and CFD trading by hedging a single share position with a CFD when the market is volatile.
Let's say you have 1,000 shares in Qantas and a natural disaster has occurred which is resulting in cancelled flights. Currently valued at $2 a share, you are worried that the value of your shares might fall, but you aren't sure.
Rather than selling your position, you decide to hedge using CFDs. You go short, or sell, 1,000 Qantas share CFDs at $2 to offset your share investment.
If the price of Qantas shares rises to $2.50, you have made a $500 profit on your shares. However, this has been offset by a $500 loss on your CFDs, which you sold with the expectation the value would go lower. If this happens and you believe the market will continue to go up, you can close the CFD position, cutting your CFD losses while enjoying your share profits.
If the share price drops to $1.50, you have made a $500 loss on your shares. However, you made a $500 profit on your CFDs which cancelled out your loss. Once you think the price has bottomed you, you can close your CFD trade and take your profits, holding onto the shares for when their price rises again.
If the price of Qantas shares remains flat, you wouldn't make a profit or a loss on either trade.
CFD hedging strategy #2 - pair trading
Pair trading is when you buy a CFD of one company and sell a CFD of another company in the same industry. As shares of companies in the same industry tend to move in the same direction, one CFD should always be making a profit while the other one is always making a loss.
Often traders buy a CFD on the share of the strongest listed company in the industry, while selling one of the weakest companies in the industry, the theory being that any gains will be larger in the strongest company than in the weakest, and any losses will be larger in the weakest company than in the strongest. This method is used to make enough of a profit to offset any losses, as well as to make a net gain.
If banking was looking strong, you could go long on Commonwealth Bank (CBA) share CFDs, but short on Bendigo & Adelaide Bank share CFDs. Then, if the CBA rises by 1.4 percent, and the Bendigo & Adelaide Bank is up by 0.5 percent, the losses you sustained on the Bendigo & Adelaide Bank trade have been offset by the CBA trade. In fact, not only have they been offset, they've been overcome.
However, it is also possible for both CFDs to move in opposite directions, such as when company-specific news is released. In this case, both CFDs could move in your favour, or against you.
CFD hedging strategy #3 - index diversification
You can also hedge the overall risk of your account by diversifying your investments across a broad spectrum. A good way to do this is by investing in stock indices - if you think the Australian market is going to go up but you aren't sure which shares to invest in, you can simply take a long CFD position on the ASX200.
CFDs are also inherently diverse as they are offered on a wide range of financial instruments, including global shares, Forex, stock indices, commodities, binaries, options and rates and bonds.
CFDs are a useful tool for protecting your investments in the long term and, as CFDs are a geared product, the need to manage risk is imperative. Although hedging minimises risk, it also reduces the profit potential, especially in the short term. This means that wildly successful gambles may be sacrificed to maintain smaller, more consistent profits over time.