Hedging with CFDs

The Need to Hedge CFD Positions

Risk management is a primary component of any solid trading plan, and with the significantly higher potential risks of CFD trading, it is all the more important. Without proper risk management, CFD trading is not going to end well, where the risk of substantial losses that your broker warned you about will surely come to pass, and in short order.

Hedging with CFDsWith other types of trading, hedging your positions, meaning ensuring that your asset balance is structured to look to mute the risk of particular trades, isn’t anywhere near as big of a deal, and in fact in some cases with certain strategies may not even be a deal at all.

If someone is trading stocks or ETFs, for instance, with the much lower amounts of leverage involved, a good trader isn’t even going to probably worry about any of this, and can usually put all of their eggs in one basket so to speak quite comfortably. For example, you might hold all of your account balance in a certain stock play or ETF, and simply manage the risk with the proper exits and stop losses, and the worst case scenario will still be comfortable and quite ordinary actually.

If you aren’t trading with an advantage, then that is another matter, but this is a different type of risk. When you are trading with a good advantage though, you are still subject to drawdown risks, where the overall expectation of the trading plan is positive but the outliers simply expose you to too much risk, and this is the sort of risk that hedging with trading addresses.

There are two main strategies that we need to be aware of when hedging with CFDs, which are how much of our account we want in play to customize the actual amount of leverage that we actually use, and to also ensure that when we take multiple positions we are aware of how the assets relate to each other to be aware of the risk that multiple positions pose.

Leveraging with Cash

The extreme example of how not to trade CFDs is to trade with very excessive amounts of leverage, if these excessive amounts are available, 500:1 for example, and expose your entire account balance to this risk.

No matter how good your trading system is, it needs to be given some breathing room. Within a strategy, there is going to be a certain amount of what we could call bad luck that arises, normal amounts to even unusually high amounts at times.

If you win 6 times out of 10 for instance, we know that there will be normal and not unfrequent distributions where you can go through several losing trades in a row. Even with tight stops, if you happen to lose 10 in a row, you still need to be left in pretty good shape, without suffering any significant damage.

When we use excessive amounts of leverage, we then become faced with the prospect of anywhere from very significant damage to our account balances to being completely taken out of the game and even left owing our broker on top of losing all our money, and this is not something we want to mess with.

When we look at the probable outcomes of our trading systems, while it’s nice to look at things like overall return, especially when this ends up looking very good or we have high expectations with it, it is obviously important to be able to stay in the game and not go broke as this all plays out.

If we don’t manage this properly, we can see otherwise good trading plans turn to bad, and even turn to disaster. Brokers will often give us way more than enough rope to hang ourselves should we wish to do that, but this only happens when we aren’t paying enough attention to the risks that we expose ourselves to.

So, the primary tool that we have to manage risk is to hedge our positions with cash, where we’re only exposing a certain percentage of our account to the market at any one time, in order to dial down leverage to what ends up being an appropriate amount.

If your broker provides you with the ability to leverage a certain asset 100:1, and you discover that you cannot manage risk well enough with more than 25:1, this means that you only use a quarter of your account at one time and keep the other three quarters in cash at one time.

This may appear to be counterintuitive to some new traders who don’t really have much of an idea at all about the importance of risk management, but to expose oneself to excessive risk by not hedging enough is simply crazy. You are just asking for trouble and it’s just a matter of time before you get seriously hurt, no matter how good you are at picking good plays.

Traders who think this way also tend to be bad traders overall, so it’s often not even a matter of their preventing their demise by hedging, at least until they turn that part around and get profitable, although not hedging properly will certainly hasten it, and usually by a lot.

The kind of hedging that new or unproven traders need to take on is of a much greater magnitude than successful and proven traders require. In fact, any leveraging at all of a plan that has negative expectations will by definition accelerate the disadvantage, meaning that you are going to be losing money even faster. The more you leverage, the more you speed up your losses.

However much hedging a trader requires is going to be a product of their skills, and those who trade very well may be able to handle higher amounts of leverage like 30:1, but you have to get there first. It’s far better to be cautious here than not, especially if you are throwing caution to the wind, as these winds will blow you down if you aren’t careful enough.

While we may normally think of hedging as balancing off positions in different assets, hedging with cash is another asset, and this type of hedging is very important in managing one’s CFD portfolio properly.

Hedging Multiple Positions

We also need to be aware of the way that multiple positions that we may be in correlate with one another. An example of this would be trading several positions that all involved the U.S. dollar, several forex positions for instance, where if we are betting one way or another on the dollar, or whether our positions may be mixed, is something we need to be aware of.

As a general rule, since we want to protect against downside risk and risk in general, it’s best to assume that risks are not offset by our different positions unless there is a good reason to assume otherwise.

Some traders may think, for instance, that they need to manage risk per position, and in our example they may take 3 different positions where they benefit if the U.S. dollar gets stronger but pay the price if it weakens.

The goal in this case needs to be to only commit the amount you would be comfortable putting in one of these positions in the cumulative total, or at least not a lot more, because they will tend to behave similarly. Forex pairs are not completely correlated of course but they are pretty close actually, and most importantly, can all move against you in a similar way.

Some traders will think that their risk exposure needs to be determined at the trade level, for instance thinking that they are prepared to risk 1% or 2% or whatever they decide on a given trade. If they aren’t comfortable with, say, more than 1%, if you have 3 trades that tend to move together and you risk 1% on each, your risk is essentially 3%, three times your tolerable limit.

This is why, in this case, the total exposure should only be 1%, meaning that you need to trade these at only a third of the size you would want to trade with if you were only trading one of these. This is, by the way, why CFD trading is so qualitatively focused, as in this situation, you may indeed only want to trade one and pick the best one.

If the positions are to some extent negatively correlated, as would be the case for instance if you bet against the U.S. dollar in one position and bet for it in another, this may involve the opportunity to not only use full positions with these trades but even go larger than that. Since one position tends to hedge another, this serves to offset some or a lot of the risk that would be present if you only traded one.

There is nothing particularly magical or exciting about trading this way though, as such a strategy tends to offset profits as well as risk, and for many traders this ends up adding complexities to one’s trading that one may not need or should welcome.

It is far better to look to master the simpler stuff before taking on more complex trading strategies such as this, and until you really know what you are doing, more trades represent further opportunities to screw them up.

The most important thing is to simply be aware of how different assets behave, things like gold and the dollar being inversely correlated, different stock market indexes being strongly correlated with one another, and so on.

As one develops their skills as a trader, one can then look to mix in things like hedging with gold to manage risk of other trades. This requires that one get a good feel of how much to hedge with, as you only want to use this to offset the risk somewhat, and playing positions where one goes up as much as one goes down isn’t the goal, because we’re looking to capitalize on your positions not just look to neutralize them.

One can also use things like well out of the money options to hedge CFD positions, which one can purchase very cheaply but get some good protection against the big stuff, such as black swan events where asset values fall off the table, or even to protect against gap risk if you are holding positions when the market is closed.

Risk management is extremely important with CFD trading. This needs to be the first order of business for any aspiring CFD trader. Hedging of some sort is a vital element of any successful CFD trading strategy.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: [email protected]

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