CFD Trading Education

CFDs are bought and sold, just like shares. CFDs are not shares however, but their prices will move almost precisely as the share they cover. So, BHP will have a CFD counterpart. In most cases, if the cost of BHP rises by ten cents, then the BHP CFD will also rise by ten cents. Rather than really owning the underlying shares, you’re only entitled to, or are liable for, the difference between your purchase cost and your selling price.

CFDs are leveraged products. You only place up a fraction of the notional share price to control the exact same quantity of shares. The leverage provided by some CFD companies can be as high as 33 times, but is generally around 20 times. This indicates that for $100, we get exposure to $2,000 worth of shares.

When buying CFDs, we successfully are putting up $100 within the transaction and the CFD supplier puts up the other $1,900. The CFD provider then gives us the exact same exposure as if we had gone out and bought $2,thousand shares on the Asx ourselves. For the opportunity of basically borrowing $1,900, the CFD provider will impose on us an rate of interest. This is usually the cash rate plus 2% or so, or around 7.5% pa.

Now, the excellent point about using CFDs to hedge is the fact that we will be sellers of CFDs. When we sell CFDs, the CFD provider will usually pay us an interest rate from the cash rate minus 2% or so, or close to 3.5% pa.

The long and the short.

Hedging with CFDs utilises the concept of short selling. When we short sell we’re attempting to sell prior to an anticipated tumble in the share price. Let us say you own 1,thousand AWB shares which are trading at $6. It becomes public that management have been involved in some relatively shady deals with the former Iraqi Government. You expect AWB shares to fall in price. To prevent the anticipated falls, you would sell AWB immediately right?

Precisely, so you sell at $6 and get $6000 back again into your bank account. Let us say that your hunch is right and AWB shares tumble to $4. The scandal blows over, and also you decide to buy back again the AWB shares at $4 because they now look inexpensive.

Now, it ought to be obvious that by getting this fast action you have saved your self $2000. You still have one thousand shares of AWB from the start of the transaction, but you have successfully created a notional profit of $2,000 – this quantity is still sitting inside your bank accounts after the transaction is finished.

Short selling uses the precise same concept. You’re looking to sell first, and purchase the share back again later on following when it falls. The only distinction with short selling from regular selling is the fact that we don’t need to own the shares prior to we sell them. In the above example, we did not need to own the AWB shares to short sell them. With CFDs, we can simply sell them at $6, after which buy them back later on at $4. In this case, rather than producing a saving we are producing a profit of $2,000.

So, that’s short selling. We like to think of the term “short” in this context: “Sure, I would like to buy you a drink after work, but I am a bit short today”. Short refers to not having some thing at first.

As we stated above, selling a CFD is like selling the real shares. The idea is that if we sell a CFD corresponding to the shares within our portfolio, and the price of those shares tumble, the profit from selling those CFDs will compensate us in the tumble within the exact same shares we are holding.

Let’s look at an example: For continuity, let us use the AWB example above. AWB CFDs have a leverage of 20 times. This means that to completely hedge our 1,000 AWB shares really worth $6, we only have to put up one-twentieth of the value of AWB shares, or $300 to short sell 1,000 AWB CFDs.

So we place $300 aside within our CFD accounts and click the sell button for 1,000 CFDs on our CFD trading platform. For all intents and purposes, short selling 1,000 AWB CFDs is exactly the same as selling your actual AWB shares.

When AWB falls to $4 one month later on, we have of course lost $2,000 on our share position. The good news however, is the fact that the value of our CFD accounts has risen by an equal and contrary amount. In addition, we’ve actually accumulated some $17.50 in interest from our CFD supplier for becoming short! So, actually, we have made a small net profit by using these CFDs to hedge.

What’s the downside? Well, as with something in life there is one – so do not get too excited. If AWB shares rose, we would similarly make an equal and opposite loss on our CFD accounts from our CFD short position, than we would make on the AWB shares from their cost increase. Within the above instance, we would have lost $2,thousand on our CFD accounts. This would need to be financed from elsewhere – either selling some of our AWB shares – our straight out of our piggy banks!

An effective short term hedge.

So, there is a trade-off for this very efficient perfect hedge. Despite this however, shorter-term, targeted hedging strategies utilising CFDs are perhaps the most effective methods of hedging a share portfolio.