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Best Practices For CFDs Trading: Hedge And Be Careful From Over-Leveraging

by CFD Guru Team   ·   
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The essential metric for determining how good a CFD trade is, is its profitability.

Meaning, we determine whether a CFD trade is good by simply determining if it makes a profit or not.

While this is not the case for other forms of trading, there are some best practices tailored specially for CFD trading, that will be discussed in details in the article below.

how to trade smart with CFDs

Best practices for CFD trading

Measuring success of CFD trading is simple – as long as it’s able to make profits, it’s determined as a successful trade.

There are many reasons investors take advantage of the versatility of CFDs and the options for creating leverage on a 24-hour trading basis means that learning how to use CFD trading best practices is the key to successful trades.

As any other career requires, trading also involves gaining knowledge and developing skills and techniques that lead to success by practicing.

Decision regarding going short or going long isn’t something that can be taken on the flip of the coin as there are many factors like up-to-date market data and price information, that are to be considered for sure.

As many other disciplines, practicing CFD trading can make this career path more and more lucrative.

Once you decide to start trading for a living, you might want to ensure your funds. One of the best practices for CFD trading is hedging, that makes it possible for you to protect your wealth.

Let’s explain what is hedging, what advantages and disadvantages hedging holds, when to hedge and when to avoid it.

What is hedging?

Hedging is a risk management strategy used for limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities.

In effect, hedging is a transfer of risk without buying insurance policies.

Hedging employs various techniques but, basically, involves taking equal and opposite positions in two different markets (such as cash and futures markets).

Hedging is also used to protect one’s capital against effects of inflation through investing in high-yield financial instruments (bonds, notes, shares), real estate, or precious metals.

What is hedging in CFD trading?

As hedging is a risk management approach in general, hedging in CFD trading is also a way to protect your funds by hedging one investment by making another.

This is done in order to insure an open position and offset risk of adverse price movements in a volatile market.

Hedging is possible with CFD trading as both long and short positions are available.

Let’s imagine that you wanted to invest in USD, but you wanted to insure yourself against specific volatility, perhaps when the monthly non-farm payroll data is due to appear, you could buy EUR/USD and sell USD/JPY.

This way, if the price of USD falls, your balance will keep neutral, meaning you’ll end up avoiding losing a lot of money in the trade.

However, keep in mind that traders still may be exposed to loss due to fluctuations in the opposing currencies of EUR and JPY.

When the price of an asset is expected to fall, many traders employ the insurance strategy that hedging provides.

Let’s discuss the hedging strategy insuring your CFD trades.

However, it’s important to keep in mind that hedging works the best when the trades (despite going long or short) is going to be held for a long time while the hedging is to protect from the short term movement/news.

Hedging Strategy: Price Asymmetry

When the price of an asset is expected to fall, many traders employ the hedging strategy.

However, this doesn’t prevent the prices from dropping.

No insurance strategy can stop any negative event or data.

The key and at the same time the advantage for this kind of strategy is that when you don’t want to close a specific position, you can open another one, that you believe will counterbalance the existing trade.

This strategy is called price asymmetry and it enables you as a trader to (1) profit and (2) trade multiple associated assets to protect against market risk.

However this strategy assumes that the price will retrace and therefore yield a return. If it does not retrace then the trader risks losing funds.

Advantages and Downsides of Utilising CFD Hedging Strategy

Why Hedge?

You might have a question as you read this article about hedging and ensuring your trades – CFD traders do not hold the underlying asset, so why hedge? Let’s discuss the advantages of using hedging strategy while trading CFDs.

Tax Effective

Hedging while trading CFDs is much more tax-effective related to selling your holdings when you see a pessimistic trend and buying them again later on.

Locking In Profits/Losses

The most common reason to hedge is to lock in profit or loss without closing the trading position.

Let’s imagine you believe ExxonMobil will report positive quarterly data in a week’s time, so you have a buying position on ExxonMobil stock.

But the price of oil is expected to fall due to overproduction and the stock is expected to fall with the price of oil.

You will hedge by opening an additional selling position on ExxonMobil for a specific amount of time to avoid the losses made on the original position.

A popular motivation for hedging is to gain protection from pessimistic market periods or economic downtrend.

Margin Level

The Margin Level shows how close your account is to a margin call.

Decrease of margin level, the account bears an increased risk of liquidation.

Traders often restore their account’s margin level by hedging their open positions.

Market Downturns

As you already know, the most common motivation for hedging is to gain protection from pessimistic economic periods or market downturns.

Let’s imagine that due to the UK economic situation, GBP is often under pressure against exhange rate fluctuations.

If you want to hold a long position in GBP/USD during an ongoing upward trend, but are aware that the market is cautious, then you can also open a short position in GBP/USD in order to balance different currency exchange rate fluctuations, inflation and other factors.

However, if GBP trend goes downwards, you will need to reassess the hedged instruments or else you’ll risk losing funds.

While there are all these perfect advantages, hedging also contains some risks that you should be aware of before employing the hedging strategy in order to ensure your funds while trading.

Risks of Hedging

Before pointing out any specific risks that are related to hedging, we’d like to inform you that the risk of short hedging is much greater than hedging when going long, as with going short, your losses may be potentially limitless and you can find yourself in a “short squeeze”, while with going long, you cannot lose more than your initial investment.

There are three main risks you should be aware of before deciding to hedge your funds while trading CFDs.

First and most important risk is that when you hedge, the asset price falls, meaning that any balance maintained by the price asymmetry strategy on multiple trades will be void and you will risk losses.

Second risk involves currency of the trading asset changing against the currency of your account. This kind of change can easily wipe out any potential profits.

And the third risk is that each position a trader opens has a spread.

The spread is the difference between the buy and sell price charged by the broker.

You as a trader need to monitor trades in order to ensure that the spreads on the assets don’t exceed any potential profits.

If you forget this factor, you’ll lose a lot of money as a result.

When to get Involved and When to Avoid CFD Hedges

As we’ve covered the risks of hedging alongside its hilarious advantages, it’s important to know how to hedge without over-leveraging yourself.

So now let’s discuss when to get involved and when to avoid CFD hedges.

So when should you get involved in CFD hedging?

There are three main points when it’s good to hedge your funds.

  • When the wider market or a particular stock you are invested in is moving against you.
  • When the wider market looks weak and doesn’t react to positive or negative news.
  • When a market position has already moved sharply in the direction of your trade and additional gains may be marginal.

And when should you avoid hedging?

There’s two occasions, when avoiding hedging while trading CFDs is the best decision to make.

  • Avoid hedging in general raging bullish markets, when everything seems to be going up.
  • When a trade has moved sharply against you, the market is prone to reversing. And by hedging near these levels all you would be doing would be locking yourself into a great loss.

Example:

Let’s imagine that you hold 10,000 Marks & Spencer shares.

You think that the price has been down for a while, but you don’t wish to sell your position for capital gain reasons or perhaps even due to the dividend yield.

With a looming VAT increase, which you believe is likely to result only in some short-term stock weakness, you still believe that Marks & Spencer is still probably a good long-term investment.

Originally, you bought the 10,000 Marks & Spencer shares at $227 for a total of $22,700.

At the moment, Marks & Spencer is trading at $346 but you expect short-term price weakness due to the VAT increase making merchandise dearer to buy so you decide to hedge your position rather than selling the shares outright.

So you sell an equivalent number of CFDs at the current market price to offset your share investment and create the hedge.

That will be 10,000 Marks & Spencer short CFDs at $346 to cover the 10,000 of Marks & Spencer share you own.

Given that CFDs are traded on leverage, you only have to pay 10% of the total value of Marks & Spencer shares – at a cost of $3,460 (10,000 x 346 x 10%).

At this point one of the following three scenarios can take place:

Stock price rises – if the stock price of Marks & Spencer rise, you gain on your stock trade but this is offset against the loss on your CFD trade.

So for instance if the stock price rallied from $346 to $390, you would make $4,400 on your share trade but lose $4,400 on your CFD trade.

If you believed that the stock price is going to keep rising you would always close the hedge by buying back the CFDs you sold.

Stock price falls – if the stock price of Marks & Spencer were to fall, you gain on your CFD trade but this is offset against the loss on your stock trade.

So for instance if the stock price fell from $346 to $300 , you would make $4,600 on your CFD trade but lose $4,600 on your share trade.

If you believe that Marks & Spencer will stop falling you , you could close the hedge by buying back the CFDs you sold.

Share price stalls – if the stock price doesn’t move, you will neither gain nor lose on either your shares or CFD trade.

This hedge is particularly effective if most of your money is invested in one or two shares.

Irrespective of the stock price movements, the hedge allows you to retain any profits from the point at which you employ it.

So as you can see, hedging is a perfect decision in some cases, while in other cases it may contain serious risks that will cost you a lot of money.

That’s why you should be careful before taking the decision whether to hedge your current trade or avoid it.

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