Learn how to diversify your risk through hedging strategies
ABC – Chart
Let’s assume Client A bought 1000 shares of ABC (ASX 200 component stock) at the price of $15.43 on 15 April ’10, and soon after the price came tumbling down.
What options does Client A have at this point? Assume bearish conditions.
1. Cutting losses
In normal cash trading, if the client held on to the position till 10 June ’10 and sold it off at $13.24,
|Losses||= ($13.24 - $15.43) * 1,000 = - $2,190|
|Commission||= ($15,430 * 0.28%) + ($13,240* 0.28%) = $43.20 +$37.07 = $80.27 ($88.30 with GST)|
|Exchange fees||= $7.84 + $6.73 = $14.57|
|Nett Profit/Loss||= ($2,284.84)|
2. Wait for price to rebound higher than entry price to sell
How to potentially hedge away such risks using CFD?
Some investors may have a view that the trend will continue but is concerned about a reversal. In these cases the investor can choose to hedge and establish an opposite position in a CFD which enjoys high correlation but smaller in contract value.
1. Hedge with ASX 200 Index CFD
To hedge positions, Client A can choose to short sell 3 contract of ASX Index CFD at 5025.0 on 15 April ’10 and buy back at 4410.0 on 11 June ’10.
|Gross Profit/Loss||= $615 * 3 = $1,845|
|Commission||= $0 (built into the market spread)|
|Nett Profit/Loss||= $1,759.14|
Client A profits $1,759.14 from this hedging position, instead of losing $2,284.84. Overall, he would only lose a net loss of $525.70 from this hedge.
N.B.: Bear in mind that the contract value shorted for the ASX 200 Index CFD is larger than the ABC Long position and as such can be taken as a short-biased trade using original LONG ABC as a hedge. ASX 200 index CFD would be appropriate as a partial hedge assuming ABC was a large component stock.
2. Hedge with Share CFDs
Some clients have the view that once they are not in the market, its very hard for them to re-enter. As such, some clients still choose to hedge using the same counter.
Client A can short-sell ABC by using Equities CFD at $15.43 and buy back at $13.24.
|Commission||= ($15,430 * 0.1%) + ($13,240 * 0.1%) = $28.63 ($31.50 with GST)|
|Nett Profit/Loss||= $2,075.47|
Client A profits $2,075.47 from this hedging position, instead of losing $2,284.84. Overall, he would only have a net loss of $209.37 from this hedge.