CFD Trading Strategies: Hedging
When markets show substantive increases in volatility, many traders will look for ways to protect their assets from unpredictable (and sometimes extreme) movements in price. One of the most common CFD trading strategies used to achieve this is the hedging method, used to balance asset exposure and prevent future losses. Hedging can be effected either by taking opposing positions in correlated markets or, more directly, by buying and selling the same financial instrument, offsetting the risk seen during volatile trading conditions.
This strategy is typically used when prices are fluctuating at higher than normal levels or when investing in assets with wide trading ranges (such as many commodities or currencies with low levels of liquidity). The hedging method can also be used when a CFD has reached your profit target and you want to lock in gains without actually closing the position. Hedging is essentially the lowest-risk trading strategy as it is, by design, meant to eliminate risk completely.
Protecting your profit
Next we will look at some specific examples of this CFD trading strategy at work. First let’s assume that we have a successful (‘in the money’) CFD position in Google stock that is currently open. Prices have risen 2% from our buy entry price and we believe that the current uptrend is in danger of reversing. In this case, if we want to protect our gains, we have two choices. We can either close the trade completely, or we can open a sell position (a ‘short sell’) in the opposite direction, in order to balance our total exposure. This gives us two equal-sized open positions (one buy position and one sell position).
If prices continue higher, the buy position will accrue gains while the sell position accrues losses but there will be no change to our total profit once the hedging position is open. If prices do reverse and a downtrend develops, the sell position will move into profit while the original buy position loses some of its initial gains. The total profit, however, remains the same. As you can see, the hedging strategy allows for the total elimination of risk from your CFD trading because it is impossible for new losses to accrue once the second position has been established.
Hedging against uncertainty
Now let’s look at some of the benefits of hedging during times of volatile price activity and uncertain market environments. There are a wide variety of events that can lead to drastic increases in market volatility, such as when a central bank decides to raise interest rates, a company releases a significant corporate earnings report, or a large-scale geopolitical event occurs. Since such events are not uncommon, traders need to be aware of the various CFD trading strategies that are available when market activity becomes less predictable.
Assume again that we are currently in a buy position in Google stock that is ‘in the money’ with a gain of 2%. We might look at the corporate earnings schedule, however, and see that Google will be releasing its annual report during the next trading session. Since this will most likely lead to unpredictable volatility in the stock price, we open a sell position in Google stock (of equal size) to protect against the price changes that are likely to follow the earnings report.
You should remember, however, that not all changes in market volatility can be predicted so easily. Influential geopolitical events or surprising changes in macroeconomic data can lead to unpredictable results in the asset markets but, using hedging strategies, CFD traders can reduce exposure and shield their open positions once these changes are identified. Another important factor to remember is that the elimination of risk also means that it is impossible to accrue gains, so hedging should not be viewed as a viable strategy for all trading environments.
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