Contract for differences, more commonly known as CFDs, can play an integral role in any portfolio, particularly when it comes to hedging your investments.
A CFD is a contract between a buyer and a seller requiring the buyer to pay the seller the difference between the current value of an asset and its value at contract time.
CFDs are available on a variety of markets, including indices, shares, FX, commodities and some cryptocurrencies.
CFDs come in handy as hedging tools, allowing investors to profit from falling markets.
This in turn gives investors the opportunity to hedge an investment, explained Fiona Cincotta, Senior market analyst at City Index.
“With CFDs you can either buy, also known as going long, which means that you make money as a market ticks higher and increases in value,” she said.
“Or you can sell, also known as going short, and make money as a market decreases in value.
“By going short in a market, you could actually hedge an investment you hold elsewhere, reducing your liability.”
So if you hold shares in a company with a share price that is moving lower or that you think will decline in the short term, but continue rising over the longer term, you could sell short.
If the share price falls, you may lose money on the physical shareholding, but profit on the short position CFD.
Traders may decide to hedge all or part of their position.
A hedge that removes all risk from a position is called a perfect hedge, explained Tony Sycamore, City Index market analyst.
“For example, let’s assume an investor had a $300,000 portfolio of mainly blue-chip ASX200 shares, and the ASX200 is trading at 7300,” he said.
“A one-point move in a CFD contract on the Australia 200 CFD is equal to $1.00. By selling 41 Australia 200 CFDs it provides a hedge equivalent of $300,000, which is the same as the portfolio value “If the Australia 200 Index falls 10 per cent or 730 points to 6570, then the CFD hedge will make $29,930 (730 points x 41 contracts), offsetting some or all the falls in the portfolio’s value.”
When uncertainty threatens your portfolio, CFDs can be used to quickly protect against falling market prices.
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