Hedging your losses, and making profits, using CFDs

Not everyone lost money in the past couple of weeks of market gyrations. Plenty made tidy profits short-selling CFDs on stocks or indices they guessed would be sold down as the market over-reacted to the bad news on sub-prime mortgages. Others used CFDs to protect the value of their existing share or CFD holdings.

Harley Salt, head of sales, Trading, at IG Markets, says that when the market came off recently, around 30% of clients had short positions open – either to hedge the fall in their long portfolios, or to profit from the short-term falls. It’s a sign that Australian CFD traders are becoming savvier when it comes to capitalising on a falling market, he says. “Previously when the market fell like it did, you’d have clients closing out positions and sitting on the sidelines until the market trended back up. But now clients are welcoming the volatility as it does create trading opportunities.”

Matthew Press, head of sales at First Prudential Markets, says all the provider’s clients were engaging in some kinds of capital protection strategy during the recent period of volatility. “A lot of dormant CFD accounts were reactivated as clients took short positions either on the index or on the individual stocks,” he says.

CFDs are certainly one of the easiest ways of dealing with, or profiting from, a volatile market. While options have long been used to offset short-term falls in share prices, and it is possible to short sell some shares, short selling CFDs is as easy as buying them. Just as with buying CFDs long, you can short sell CFDs at a fraction of the share price – usually around 3% of the total face value. However, instead of paying interest as you do with long CFDs, you receive interest (on the basis that you are ‘lending’ money rather than borrowing) and you pay dividends rather than receiving them. After that it is a matter of working out the effects of the high levels of gearing on either your profit or loss depending on how the market, or the stock, moves.

If you buy 1000 CFDs on $10 shares at a 3% margin (a total of $300 not counting commission), if the price drops as predicted by 50c, then you will be ahead around $500, a 60% profit on your original outlay. If on the other hand, the share price increases by 50c, your loss will be $500 – more than your original outlay.

Hamish McCathie, director of CFD Trading, recommends using a CFD index to hedge against falls in the wider market. “If you can’t short the index,” he says, “you shouldn’t be trading CFDs. You’ll end up as a sitting duck because you’re always going to have broad market movements in response to shocks like the recent sub-prime crisis.”

The added advantage of trading the index is that it can also be traded overnight, Salt adds: “If the Dow Jones is falling clients can protect themselves or capitalize by entering a short on the index right then, they do not need to wait until the stocks open up well after the US market shuts.”

Depending on the CFD provider you can short the index either directly through the market maker, or via direct market access (DMA) by short selling a CFD on the SPDR S&P/ASX 200 ETF (formerly known as StreetTracks 200).

Another more specific way of hedging in shaky markets is to short sell an exactly correlating number of CFDs as you hold the stocks of – thus ending up with a zero net position. Press says many clients with long term equity portfolios short sold CFDs against their stock holdings during the market wobbles with the aim of neutralising their exposure.

“It also means that if you have a large capital gain and want to lock that in but don’t want to realise the capital gains, you can short CFDs over those stocks for capital protection and to give you the time to assess the market position before you make your final decision as to whether to hold or sell,” Press says.

Other more adventurous CFD traders used CFDs to short stocks or the index to make a tidy speculative profit. Traders who managed to short-sell MBL when it fell from $90 to $75 in late July, early August in the wake of the sub-prime crisis would have done very well for themselves. Selling 1000 MBL CFDs at $90 and then buying 1000 MBL CFDs at $75 would have yielded a profit of $14,835 on their outlay of , for instance.

Press says those of his clients employing strategic short term trades – either short or long – tend to be active traders, relying on technical analysis to make decisions as to where the market is heading. “They are watching the market like a hawk,” he says. “You do have to be very flexible and nimble. It’s about managing your position overnight depending on your analysis of where you’re expecting the market to go.”

CFDs are a product well suited to changing direction quickly – a scenario that is all too familiar to investors and traders at the moment as the credit crisis continues to pay itself out. “The beautiful thing about CFDs is that you can still make money even if the market hits its head,” says McCathie. “History’s proven that the market wants to go up. But along the way there are always going to be hiccups and for a leveraged player it’s a matter of making sure you are hedge for that possibility so you don’t get burned too badly.”