What Is Hedging in CFD Trading When And How to Use It
Contract for Difference (CFD) trading holds the promise of vast profits, but it carries large risks, too, because of how volatile the markets are and how much leverage you use. It's precisely this scenario that makes hedging the most valuable tool in the trader's toolbox.
But let's not jump to the why of hedging without first covering the what. What exactly is hedging, anyway? And how can a trader put it to use in the context of CFD trading?
At its simplest, hedging is a risk management strategy. It serves to protect against potential losses in one investment by taking an opposite position in a related asset. It's not financial insurance, but it sort of works like that. You're not trying to eliminate risk, but rather manage and minimise it to protect your capital.
Why Traders Use Hedging in CFD Markets
Hedging in CFD trading is primarily motivated by the need to manage downside risk in today's volatile markets. Modern financial markets are capable of experiencing "dramatic price swings" in a matter of minutes, especially during a "major news release, an announcement of economic data, or an unexpected geopolitical event."
Think about the psychology of trading: when a trader is holding an unhedged position during a significant market event, it can be quite stressful. And we all know that stress can lead to poor decision-making, including the all-too-common mistakes of closing out what should be a winning position far too early or, conversely, hanging on to a losing position far too long. Therefore, I would suggest that another potential reason for using options to "hedge" (that is, to offset risk in a stock position) is for the peace of mind it can provide.
Common Hedging Strategies in CFD Trading
When you are pretty sure of the long-term direction your trade will go but want a safeguard against slingshots or other such temporary volatility, direct hedging is an excellent choice. Its primary advantage is simplicity: If you're hedging with the same instrument, the correlation is perfect. But the downside is that you incur extra costs and also have to maintain a position with a larger margin requirement.
One of the simplest ways to hedge is to take the exact opposite position in the same instrument. Say, for example, you were long 1000 shares of Apple CFD and you wanted to hedge against short-term downside risk but still keep some of your position. You could open a short CFD position for 500 shares of Apple. Now, you're forced to think a little bit down the road and in somewhat of an opposite mindset to create a hedge that lets you stay partially long and, thus, allows you to maintain some of your upside potential.
When to Use Hedging – Timing Is Everything
Hedging well isn't a matter of always protecting against losses – it's a matter of protecting against losses at the right times. The best times to hedge are just before we expect big market moves that could result in significant changes to our positions. Huge economic reports like Fed meetings, Non-Farm Payrolls, or major earnings announcements are great times to think about whether our current portfolio is positioned for the next big move.
The weekend and overnight risk is another vital timing factor to consider. When the market is closed, news can break that dramatically changes investor sentiment. The market can open a few points up or down; it can gap. If you're not concerned about the risk of being in the market, but you don't want to hedge your positions entirely over the weekend, consider a risk reversal.
Pros and Cons of Hedging in CFD Trading
The prime benefit of hedging is that it significantly minimises risk. You can take prospective losses and beat them back with opposite positions that, when you look at things in an aggregate way, really work to reduce your overall portfolio volatility. Hedge this way, and it might just make you a calmer, better-rested, and less-stressed trader of the kind we all aspire to be.
Another key benefit is protecting profits. On days when you've racked up big profits and aren't entirely sure which way the market is going, hedging can help you guarantee that at least some of those profits remain yours, while still allowing for the possibility that things might improve even more. And because a hedge is like an insurance policy, it's especially valuable when the market is as troubled as it is today.
Conclusion
In the realm of contracting for difference (CFD) trading, profiting from a hedge is certainly not a direct route. Hedging is far too nuanced and complex for that. Instead, hedging is practised as part of a broad risk management regimen. For CFD traders, hedging almost fits better in the category of sophisticated manoeuvres like earning a living playing the violin, with the violin being the hedge and the living being the risk well managed.
And like most practices in that category, it can work quite well if you understand it and are using it in the right context. Or it can cause a whole mess of financial misfortune if you don't understand it and, worse, are using it in the wrong context. Unlike a lot of tools supposedly used to generate profits, you are never supposed to use this one in such a way that it creates a lot of costs. Quite the opposite.
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