How to Use CFDs for Hedging: Protecting Your Investments

Let’s think of a football game. You are in the offence and wish to score, but you also do not want the opposite team to score on you. What do you do? Play defensive, of course. You now begin planning how not to let them score on you. What do you do? Play defense, of course. You start planning how to prevent them from scoring on you. In the investing world, hedging is somewhat similar. It’s like putting up a defense, or defensive play, to secure one’s investments against possible losses.

Now, imagine that you are a trader using Contracts for Difference. CFDs represent some sort of special financial contract by which you can take advantage of the difference in the price of an asset, for instance, stocks or commodities, without owning it. They can become good tools for making money but very risky if the market against you moves in the other direction. That’s where hedging with CFDs comes in.

Image Source: Pixabay

What are CFDs hedging?

Hedging with CFDs: Putting up your defenses to minimize risks when you feel the market is heading in the wrong direction. Let’s break it down: You already have an investment, but you’re concerned that prices may drop. You open a CFD position opposite of your primary investment to protect yourself.

For instance, if you own a share of stock and are concerned that the price is going to drop, then you can use a Contract for Difference to open a short position on that very same stock. A short position means you’re betting that the price is going down. If the price on your stock falls, then the profit that you make in a CFD trade helps offset the losses on your stock position. It’s like playing offense and defense at the same time.

How does it play out in real life?

Now, let’s simplify it with a sporting analogy. Imagine you are a soccer player holding on to the ball and running towards the goal. You have the ball (your investment), but an opposing player (market risks) may steal it from you. In such a case, to prevent yourself from losing control, you place a defender (CFD hedge) who can stop any tackles and other attacks meant for you. Although the defender does not score the goal, he just stops the loss.

Here’s an example: Suppose you own shares in a company in the tech sector, but the tech sector is very volatile right now. You fear that price might drop, but at least you don’t want to sell your shares. Instead, you open a CFD position where you go short on the tech index. And if the sector falls, the profit from the CFD offsets the loss in your shares-it’s like having a backup plan.

The Benefits of Hedging with CFD

Risk Reduction: It helps protect your investment from unwanted price moves just as your defense team protects the goal.

Flexibility: You can hedge with CFDs on almost any asset, be it stock, commodity, currency, etc., just like a player can defend in different parts of the field.

Leverage: CFDs give users the opportunity to manage larger positions with a smaller amount of capital. It is as if a soccer player uses agility to run further distances on the ground.

Risk management using CFDs (Contract for difference) is a concept of defense in sports. Like setting up a defense, you protect your balance and keep your investments in the game from the big losses. Not foolproof but if used wisely, it will help manage risk, like the best team.

The fact is that hedging is not about avoiding risk but controlling and reducing it so as to be able to continue playing the game of trading smartly.