e-Book: Hedging with CFDs – Part 1 – Introduction

Hedging is the action of taking an equal but opposite position usually through a derivative, such as a CFD in order to mitigate or reduce the risk of an existing open position. A hedge will create neutral market exposure so any price changes will be offset by opposing positions.

A short hedge using a CFD is one of the simplest ways to lock in a price by short selling a share to offset the risk of any adverse price movements. A hedge allows a trader to offset any losses in a long position with profits from an opposite short position.

CFDs are a useful tool for hedging existing shareholdings because a short position can be made to hedge the exact position size required. Some hedging tools have standardised specifications and may not move in the same correlation of the underlying share. The risk that the hedge does not cover all the risk of the position is commonly referred to as basis risk. As CFDs are priced mirroring the market a neutral position hedge can be created with zero basis risk quickly and cost effectively.

Traders will short sell for two distinct reasons; to speculate and profit from selling high or overvalued shares with the intention of buying back to close the positions at a lower price in the future and to hedge risk.

Hedging via a CFD allows you to protect physical share positions without the complications of traditional short selling such as borrowing shares to sell.

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