Top CFD Hedging Strategies

Risk management is non-negotiable for traders, regardless of their experience or skill level. The markets are unpredictable, and it is only prudent to protect your positions and overall portfolio against unexpected moves. While stop loss and take profit orders are effective risk management strategies to protect a single open position, hedging can help you shield your entire portfolio. However, while a hedging strategy can limit losses, it doesn’t completely eliminate risk.

Why Hedge with CFDs?

The basic principle of hedging is to open a position in the opposite direction of an existing position or to invest in asset classes that are either negatively correlated or uncorrelated. This way, when the market moves in an unfavourable direction, the losses are mitigated. CFDs have emerged as popular hedging instruments because of its flexibility and range.

Firstly, since CFDs are traded on leverage, you only need to fund a fraction of the total value of a position. This allows you to open multiple positions even with limited capital. Secondly, CFDs can be used to go both long and short, which means you can capture opportunities in both rising and falling markets. 

Also, since they do not have an expiry date, CFDs can be used for longer-term hedging. However, since trading with leverage increases market exposure, it can magnify potential losses as much as it does potential profits. Therefore, understanding and using leverage wisely is crucial.

One of the biggest advantages of CFD trading is that you can diversify your portfolio with leverage, without overstretching your trading budget. Diversification is possibly the most effective way to protect your portfolio against unfavourable market moves. Here’s a look at some of the popular CFD-based hedging strategies.

Open Defensive Short Positions

Taking a defensive short position is a way of hedging against potential losses in a long position. This method can be used with various asset classes, including stocks, forex and commodities. In this hedging strategy, let’s say technical analysis suggests the potential of a temporary decline in the asset price, such as a specific stock. Now, the trader can short-sell a CFD associated with the stock or another asset that mirrors the price of this stock. The earnings from the sale might help balance out potential losses in a longer-term position in the stock.

However, this trading strategy requires an in-depth understanding of what moves the prices of the assets concerned.

Offset Market Shifts with Indices

Use index CFDs, which offer exposure to a basket of sectors or an entire market, to hedge against broad market exposure. It is useful for traders with well-diversified portfolios. So, let’s say your analysis suggests that tech stocks are due for a downturn, and your portfolio is tech-stock-heavy. You could consider taking a short position on a tech-heavy index, such as the Nasdaq 100, using a CFD. This way, when tech stocks do slump, the losses in your overall portfolio are limited with such market hedging. Similarly, if you expect UK stocks to decline, you could consider short-selling an FTSE 100 CFD to shield the UK stocks in your portfolio.

This method is more effective than taking opposing positions in individual stocks to offset losses. This hedging strategy also works when you expect a particular market to surge. Here, you can take a long position on an index CFD associated with that market.

Take Opposing FX Positions

To safeguard against unfavourable forex moves, you can take opposing positions in a specific currency pair. For instance, you could open a long CFD in the EUR/USD and a simultaneous short CFD position in the same pair. Alternatively, you could consider two correlated currency pairs and take opposing positions. Here, since the EUR/USD and GBP/USD share a strong positive correlation, you could take a long position in EUR/USD and a concomitant short one in the GBP/USD.

Another forex hedging strategy is to look for negatively correlated currency pairs, such as the EUR/USD and USD/CHF. Here, if your analysis suggests that the EUR/USD is likely to rise, you could take a long position in the currency pair while taking a short position in the USD/CHF, which is likely to decline when the EUR/USD rises. However, remember that like any other trading strategy, thorough research and analysis are important before opening any position.

Trade the VIX

You might already have realised that market moves are influenced to a significant degree by market sentiment. Therefore, using the Volatility Index (VIX), also known as the “fear index,” is a popular hedging strategy. Let’s say you predict an impending increase in market volatility that might hurt your portfolio. You could take a long position on the VIX via a CFD. If there is a volatility spike, you stand to gain on the VIX CFD, since its value will rise. This can help offset potential losses in your portfolio.

However, there are two things to keep in mind here. Firstly, the VIX is a complex index and could prove tricky for beginners. Secondly, if the VIX fails to surge, it could result in significant losses, depending on the size of your position. The VIX is not directly related to a particular asset, rather it reflects market sentiment. Therefore, make sure you understand how the index works before using it in your trading strategy.

Pair Trading

This strategy is based on the idea that share prices for companies in a certain sector are likely to move in the same direction. This is similar to trading correlated currency pairs. For instance, stocks of a specific sector, say AI stocks, are likely to perform similarly. So, if one AI stock performs well, others are also likely to do well. So, you could consider opening a long CFD in the stock with the strongest potential performance while taking a short position in the stock with the weakest potential for a price rise.

Regardless of which strategies you use, practice them on a demo account to refine your skills before applying them to the live markets.

To Sum Up

• Hedging helps protect portfolios against unfavourable market moves.
• The strategy works by taking opposing positions in correlated assets.
• CFDs are a popular means to apply hedging strategies since they offer immense flexibility.
• Some of the most popular hedging strategies include:
  • Opening defensive short position
  • Hedging against broad market moves with index CFDs
  • Forex hedging by opening opposing positions in the same currency pair or in highly positively correlated pairs.
  • Hedging vis VIX CFDs.
  • Pair trading by taking opposing positions in two stocks from the same sector.

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