Let’s consider share A of Ftse100 quoting at 210p to 210,25p today.
One year ago you bought share A for 10% weight of your equity portfolio at 110p.
If there are no trading commissions, no taxes and no dividends, in one year time your profit for share A is equal to the % price increase weighted for portfolio weight, or [(210p-110p)/110p]* 100 = +9% (rounded and weighted for 10% positioning).
Today you feel nervous about share A because of bad financial news that can cause a price drop, that you are forecasting in 10%, in the very short time (let’s say by next week end).
Unfortunately you haven’t reached your investment time horizon and so you don’t want to sell a portion of the share A because you don’t know if the forecast is correct and so you don’t like to face the risk to watch an unexpected rally with a decreased share A portfolio’s weight.
But if you are right about the forecasted downtrend for share A, using a passive portfolio management, you will suffer a 10% drop for the cumulated profit.
The risk is that this drop doesn’t stop in the 10% scenario and so you could lose more of the cumulated profits for share A.
Shares A fundamentals are strong and you don’t want to take profit now also because you don’t see good investment alternatives around.
What can you do to protect (to hedge) share A profits?
You can sell share A CFD investing just a portion of your portfolio liquidity: if you are long 1000 shares A, representing 10% of your equity portfolio, you can sell 1000 share A CFD at 210p (remind that share A price is quoting 210p-210,25p today).
Initial margin required is 10% and so you can invest just £210 tosell a total value amount of share A Cfd of £2.100.
If share A price is quoting 210p-210,25p today, you can sell 1000 CFDs (representing a sale for a total value of: p210 * 1000 = £2.100) paying just the initial margin of 10% and so: £2.100*0,10 = £210.
If after 1 week (your forecast was correct) share A price is lower than p210, let’s say 10% lower or 189p, also share A CFD will be lower.
You decides that share A 10% drop is enough and so you want to close the hedging.
CFDs like stocks can be bought or sold at anytime during the trading day ( when the underlying market is open) and so you decide to close the CFD position today.
If you sold 1000 share A CFD, to close out the position you have to buy back 1000 share A CFD.
If today share A CFD price is p189 – p189,50, you buy back 1000 share A CFD paying p189,50.(*)
Paying p189,50 * 1000 = £1.890,5 you are able to close out share A CFD position.
Summarizing, you invested £210 to participate to the potential profit from shares A drop, investing short in share A CFD, or selling 1000 share A CFD and you gained: £2.100 - £1.890,50 = £209,50.
CFD profit helps you to stabilize share A portfolio cumulated profit, without modifying share A portfolio weight.
Using CFDs you are in the condition not only to monitor the equity risk but also to balance your portfolio risk, hedging against possible equity drops, using just a small portion of your liquidity.
(*) Share A CFD p189-p189,50 represents the CFD trading quotes where p189 is the ‘bid’ (where CFD provider buys CFDs ) and p189,50 is the ‘offer’( where CFD provider sells CFDs). When you buy back CFDs, CFDs provider is selling to you and so you have to hit the offer price at p189,50.
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