This popular strategy uses a CFD hedge to protect a single share position.
Imagine you currently hold 10,000 XYZ Bank shares. It is October 2008 and the bank is experiencing problems due to the current credit crunch stemming from difficulties in the U.S. housing market – creating what you believe is only a short-term weakness, you believe the bank is a sound long-term investment.
Initially you bought 10,000 shares at $5.82 back in November 2005 for a total of $58,200.
Currently, XYZ Bank is trading between $7.20 and $7.40. But, with the current credit crunch, you anticipate short-term losses. However, you expect to see the share price will find resistance and increase in the future.
You decide to hedge your position rather than sell out. Therefore you sell an equal number of CFDs at the current market price to offset your share investment and create the hedge. That will be 10,000 XYZ Bank CFDs at $7.40 to cover the 10,000 shares of XYZ Bank shares you own.
Assume the margin rate on XYZ Bank is 10%, you are required to pay a margin of 10 percent of the value of XYZ Bank shares – at a cost of $7,400 (10,000 shares × $7.40 per share × 10% = $7,400).
At this point one of the following three things can happen:
Share price rises– if the share price rises, you will gain on your share trade which offsets against the loss on your CFD trade. If the share price climbed from $7.40 to $8.40, for example, you would make $10,000 on your share position but lose $10,000 on your CFD trade.
Share price falls– if the share price falls, you gain on your CFD trade which offsets against the loss on your share trade. If the share price dropped from $7.40 to $6.40, for example, you would make $10,000 on your CFD trade but lose $10,000 on your share position.
Share price stalls– if the share price stalls, both positions will be neutral and you will not incur a gain or a loss on either your share or CFD. For example if the share stalled at $7.40 you would make $0 on your share trade and lose $0 on your CFD trade. At this point, you could either retain the hedge to protect from any potential negative price movement or you could unwind the hedge and buy back the CFDs.
Regardless of the share price, the hedge lets you retain any profit from the point at which you sell the CFD to when you purchase it back.
It should also be noted that when you hold a short CFD position you receive financing on the position.