How To Use CFDs To Hedge Against Market Volatility

This article is a guest contribution provided by Forex Traders

This article is not a recommendation to trade any specific commodity. Do not take this as advice in any form. It is for general education only.

Article:

The goal of every investor and money manager in the world is virtually the same—to create alpha. When an investor or money manager buys or sells a financial asset such as a stock, commodity, currency, etc according to pre-defined trading strategy, they are generally hoping that the underlying asset will move in a favorable price direction so as to create a profit when the trade is closed.

One of the primary challenges that most investors face, however, is learning how to handle significant price swings in a volatile market. To illustrate this point, let’s use a real-life example.Let us assume that Joe Investor is your average 40 year old investor who is actively managing a portion of his retirement investments. Joe lets a professional money manager control 80% of his net worth, but he has an incredible passion for finance and financial markets in general, so to satisfy his urge to invest, Joe actively manages 20% of his net worth in a privately held portfolio.

Joe Investor is an industrial engineer by trade and he is constantly dealing with environmental issues. This experience spills over into Joe’s investing behavior, and he is extremely interested in renewable and natural energy resources. Joe believes that there will be explosive growth in the renewable energy industry over the next ten years. Therefore, Joe has found several companies that he believes stand to grow aggressively due to this growth in the industry at large, and Joe has taken long positions in each of these companies.

Unexpected Fundamental News

Let’s also assume that in late 2010, the United States Congress failed to pass some key tax cuts for companies in the renewable energy industry. As a result, 2011 is looking to be a very rough year for the industry. Companies will most likely have to scale back operations, few jobs will be created, and the industry will most likely move forward at a snail’s pace until Congress enacts some form of stimulus.

Joe Investor is still very bullish on the renewable energy industry over the next 10 years, but suddenly a new economic dynamic has been created by the failed passage of tax cuts, and the near-term outlook for the industry is very bearish. Now, Joe Investor has a few options. Joe could turn his attention to another asset class and take a forex education class, or he could sit through the drawdown and watch his investments lose value on paper, all the while believing that they will post new HI’s within the next few years.

Enter CFD Hedging

The other option Joe has is to hedge against this weakness in his companies. Joe Investor can actually sell CFDs (contract-for-difference) for the exact amount of shares that he is currently long in each of the companies that he is long. This will allow Joe to profit from this short-term bearish swing, while still keeping his long-term position trades open. This is the essence of hedging. Joe then has a few options. He can either close out the CFC short positions down at a price where he believes a bottom is in place, so as to profit from the downswing. Or he can wait for price to move down and come back up to where he went short. This would allow him to exit at breakeven on his short position, but it also protected him because if the market had tanked and never came back up, Joe Investor would be in a short position with healthy profits that would offset any losses in his long-term positions.

The Risks of Hedging

Although hedging with CFDs sounds like the way to handle volatile near-term and mid-term price swings, there are still substantial risks. Timing can be very difficult to assess perfectly. As with any financial investment, such as currency trading, equities, commodities, etc, there is always substantial risk against loss. Although hedging is typically supposed to reduce risk, there is never a guarantee against the loss of investment capital.

Guest contribution provided by Forex Traders

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