How to Hedge your CFD Position Using Options
Despite what some critics say, derivatives have their place in the modern financial world. In fact, before the advent of derivatives it was extremely difficult if not impossible to hedge a trading position. Someone going long on a stock was in deep trouble if the price of that stock dropped and there was little he or she could do about it.
Since options started making their appearance in the 1970s it has become quite easy to hedge an open long or short stock position with options. Not many CFD traders, however, are aware that options can also be a good way to hedge an existing CFD trading position.
Take the example of a long CFD position in shares of Company ABC. The risk profile for this trade looks like this:
If the price of Company ABC shares increases, the trader makes money. But is there a way to prevent losses when the price goes down?
Indeed there is. One of them is put options. If this trader should buy the same number of put options, the risk profile of the trade changes to something quite different.
In this case the trader will still make money if the price of Company ABC shares should increase, but if they drop in value this trade can never lose more than the amount paid for the put options.
In stock trading this is known as a protective put. CFD traders often are not aware that they can use exactly the same approach to protect long CFD positions against price declines.
When a trader believes that the price of an asset will drop, he or she can enter into a short CFD position on that asset. The risk profile of such a trade looks like this:
This trade will make money if the price of the underlying assets drops, but if it increases, the trader stands to lose an unlimited amount of money – unless he or she uses stop losses.
It’s quite easy to protect the trade against price increases using options though. If the trader in the above example should buy the same number of call options the risk profile of this trade will change to the following:
The trader will still be able to make money if the share price of Company ABC drops, but if it starts to increase he or she cannot lose more than the amount that was paid for the call options.
It has to be remembered that even if the price goes the way the trader originally wanted, i.e. up for a long CFD contract and down for a short CFD contract, there is still a cost to hedging. For any given price movement the trader’s profit will be lower with an amount equal to the cost of the put or call options that were bought to hedge the trade. This is the price of insurance and most traders will find it acceptable.