Portfolio protection and hedging with CFDs

CFDs are contracts for difference that are used by the vast majority of all traders for pure speculation. However, some market players use Contracts For Difference additionally or alternatively to hedge the portfolio. This is often referred to as hedging with CFDs.

In our article you will learn what CFDs actually are and why they are suitable for hedging and thus hedging portfolios. Furthermore, we will inform you about other possibilities to hedge your portfolio, which underlyings are suitable and which CFD broker you can use for hedging with CFDs.

What are CFDs?

CFD is the abbreviation for Contract For Difference. They are so-called derivative products, as CFDs always refer to a specific underlying asset. Alternatively, this is often referred to as underlying or asset. Typical underlyings to which contracts for difference refer today are:

• Indexes
• Stocks
• Commodities
• Foreign exchange
• Cryptocurrencies

With CFDs, for example, you can speculate that the Deutsche Telekom share price will rise in the future. Alternatively, it is also possible to hedge your portfolio or, more precisely, a position with Deutsche Telekom shares against losses. We will go into this in more detail in the course of our article.

The leverage is definitely one of the most important factors for understanding CFDs and how they work. In CFD trading, you only have to invest a small part of the trading value yourself, but the broker lends you the majority. For example, a leverage of 10:1 means that with a trading value of 10,000 euros, you only have to invest 1,000 euros of your own capital, while you get 10,000 euros borrowed from the broker. However, in this case, 10 percent of the trading value must be deposited as margin (security deposit), i.e. 1,000 euros.

Another feature of CFD trading is that you can speculate on both rising and falling prices of the corresponding underlying asset. This is an important basis when it comes to hedging a portfolio using CFDs. In most cases, you will hope for rising prices of the underlying asset in your portfolio, so hedging with CFDs must include speculation on falling prices. Due to the leverage, you can move or hedge larger sums with CFD trading even with small capital stakes, which is also another important basis.

Why are CFDs suitable for hedging?

There are a number of reasons why contracts for difference are ideally suited for hedging positions and thus hedging. In summary, the following are the characteristics and features that predestine CFD trading for hedging:

• Low capital investment due to the leverage
• Speculation on rising or falling prices (long and short)
• Numerous underlyings from all sectors for the respective CFDs
• As a rule, no maturity limit for the contracts
• CFD have partly longer trading hours

Some of the features on the basis of which CFDs are best suited for hedging, we have already addressed in the previous section. For example, the low capital investment due to the leverage means that the hedging of portfolio positions is easily achievable even for investors with lower assets. Furthermore, it is important that there are both long and short CFDs, so you can speculate on both falling and rising prices.

Contracts for difference are also ideally suited for hedging because they usually do not have a maturity limit. This is important, for example, if you want to have a stock position in your portfolio for many years or even decades, so that a permanent hedge must be guaranteed. Furthermore, it is important that there are as many underlyings as possible in CFD trading, so that presumably your underlying, which you want to hedge, also has a corresponding CFD. The major CFD brokers sometimes provide more than 1,000 underlying assets for CFD trading.

What other options are there for portfolio protection?

CFDs are a very good way to hedge a portfolio, but of course not the only one. However, many traders prefer contracts for difference because they are very transparent and easy to understand even for beginners. Companies, institutions or experienced or professional investors often resort to the alternatives and then use the respective instruments to hedge their portfolios as well. The other possibilities of hedging include in particular:

• Certificates
• Warrants, options and futures
• Sale / Increase cash ratio

Let's briefly discuss these individual options so that you can check whether one of these variants is suitable for you as an alternative to hedging with CFDs.

Certificates: Pay attention to different types of certificates

Even the selection of certificates is not easy, because there are several different types of certificates. For example, there are just as much guarantee certificates as knock-out certificates, although the return and especially the risk differ significantly. The first step is to find the most suitable certificate for you and your hedging project. Most investors choose leverage certificates or knock-out certificates for hedging, because they work similarly to CFDs with a leverage system.

Warrants, Options and Futures: Observe Key Figures and Time Values

Warrants, options and futures are also a way to hedge the portfolio, but they are not particularly suitable for medium- and long-term investors. The reason is that these derivatives, unlike CFDs, have a limited term. However, if you want to hedge a stock position that has been running for years, for example, you would usually only have to change the warrant, option or future several times, as the term is often limited to a maximum of two to three years.

In addition, warrants, options and especially futures are more complicated than contracts for difference because, for example, some ratios and also the time value play a greater role. Therefore, warrants, options and futures to hedge the portfolio actually in all rule primarily for companies, very experienced traders and institutions.

Sell positions and increase cash ratio

Increasing the cash ratio, i.e. the available liquidity, is also a way of hedging positions. This way you have the possibility to intervene in case of changes on the market and to buy certain underlying assets or derivatives. Often, the mentioned possibilities of hedging are accompanied by diversification, through which you can naturally also hedge positions in the respect that a risk diversification takes place.

Which underlyings are actually suitable for portfolio hedging with CFDs?

Basically, almost all financial products that can be traded are suitable as underlying assets for portfolio hedging using CFDs. Only more specialized forms of investment, such as real estate, bonds or subordinated loans, can generally not be hedged using CFDs. The vast majority of all investment forms, on the other hand, are ideally suited to be hedged against major losses using CFDs, in particular:

• Stocks
• Indexes
• ETFs
• Foreign exchange and general currency risks

The system of hedging with CFDs is basically always the same, regardless of whether you want to hedge individual stocks, ETFs or currency positions. Let's assume, for example, that for some time you have had a stock position in your portfolio consisting of 10 Amazon shares. After buying it, you naturally hope that Amazon stock prices will rise. If this does not happen, you would usually suffer losses. If you want to avoid them, or at least prevent bigger losses, you simply trade a short position using stock CFDs, more precisely a contract for difference that has Amazon shares as its underlying.

Due to the leverage, you do not have to invest the current equivalent value of your stock position in Amazon shares in CFDs, but - depending on the leverage - usually only 2 to 10 percent of the corresponding capital. Should the Amazon shares actually fall in price on the stock exchange, you will probably suffer a loss on the one hand with your share position. On the other hand, however, the value of your Amazon short CFDs increases, so that you can compensate for the loss of the stock position with the right, selected sizes. In this way, CFDs work with all of the underlyings mentioned, for example, indices, ETFs and also for hedging currency risks if you hold a foreign exchange position.

Which CFD broker do I use for hedging?

CFDs can usually not be traded through "normal" banks or stock brokers, but it requires so-called CFD brokers. There are now more than 30 of these providers on the German market, so you should make a comparison. The CFD broker comparison helps you to find the most suitable provider for you.

For example, it is important that the CFD broker also offers the underlying asset that you want to hedge using contracts for difference. To stay with the previous example, this means that you should only choose CFD brokers that also offer stock CFDs with the underlying Amazon shares.

In addition to the trading instruments, you should also pay attention to various features of the offer when comparing CFD brokers, such as a functional trading platform, the conditions in the form of spreads, whether a demo account can be used free of charge and how well the customer service is available. In most cases, a good overall package leads to the fact that it is also a suitable CFD broker.

Also helpful are experience and test reports, which are often referred to as reviews. There, the individual components of the CFD broker's offer are scrutinized and can therefore also be a good decision-making aid. In our large CFD broker comparison you will find a Overview with reviews and facts about reputable CFD brokers.