Contracts for difference

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14. Strategies: Hedging an equity portfolio

One application of CFDs is their use to hedge positions in your equity portfolio. This is best illustrated by an example:

• Suppose you own 10,000 shares in Reuters plc, priced in the market at 527p.
• You think the shares will continue to climb above 527p in the long term but you also expect the price to drop in the short term.
• You don't want to sell the shares because you consider them a good long term hold, and also because of tax reasons: you have already used up your CGT allowance, so selling the shares now would incur CGT on the gains at 40%.
• Somehow, you want to lock in the gains you've already made, but not sell the shares or crystallize a capital gain.

CFDs provide a means to do this. What you do is open a short CFD position equivalent to the 10,000 Reuters shares you own, and thereby attain a 'market neutral' position.

• If the price of the Reuters shares falls 10p, you will make a compensating gain from your short position on the CFDs.
• If the price of Reuters shares rises 10p, you will make a compensating loss from your short position on the CFDs.

Whichever way the price goes, your financial position remains neutral.

The cost of this hedge is the commission you pay to open the CFD position. And, of course, you will have to deposit a margin payment with your broker to cover the CFD.

If you have a diverse range of stocks in your portfolio, it may be impractical to hedge each one individually with a CFD. You can, though, get the same hedge benefit, albeit less symmetrically, by hedging a nearest-match index.

• Suppose you have a portfolio of FTSE 100 companies worth £100,000.
• Instead of hedging each company separately, you hedge the FTSE 100 index, by selling it short. Your broker quotes you 5160/5167, and you sell 20 CFDs at 5160. The value of the contract is therefore £103,200 (each FTSE100 CFD is valued at £10 per point) and if the margin is 10%, you have to commit £10,320 to your margin account.
• If the value of your individual stocks goes down by 10%, the price of the FTSE 100 CFD should also drop by roughly the same amount (depending on which stocks you have and their weighting in the index) and you will make a compensating gain on your CFDs.

1. What are CFDs? 2. The benefits of CFDs 3. Initial margin 4. Variation margin 5. Commission costs 6. Interest payments 7. Dividends 8. Example of a long and short trade 9. Comparison of CFDs to share investing 10. Comparison of CFD trading to spread betting 11. Types of order 12. Stop losses 13. Strategies: Pairs trading 14. Strategies: Hedging an equity portfolio 15. Opening an account with a broker 16. Conclusion

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