A CFD is preferred because it’s a highly lucrative financial instrument. Both parties involved in a CFD agreement stand to gain substantially. A Contract for Difference is an agreement set up between two parties based on a few stipulated pre-conditions. It involves the selling of an underlying asset in question.
According to the contract, the seller is liable to pay the difference in value to the buyer, at the time of the execution of the contract. If the difference in negative, the buyer pays the seller, instead of the other way round. Therefore, the proceedings largely depend on the price movements of the underlying asset. The parties are allowed to take positions and enjoy the benefits of the movements accordingly.
What Is Hedging?
Hedging is a technique which is used to cancel, minimize or completely eliminate financial risks. It is considered as an effective financial tool. CFDs are extensively used by hedge fund managers. They consider CFD to be an easy tool for gaining profit on a stock which is actually losing value in the markets. Therefore, many investors purchase a short CFD for hedging an asset which is a part of their investment portfolio.
Why Is Hedging With Cfds Preferred?
Prior to the surging popularity of CFD trading, stock options were used as an effective hedging tool. They were known to reduce risk exposure substantially. However, there is a major limitation for options. They only allow multiples of 1000. Therefore, if you own 3200 shares, you can hedge with 2000, which would be inadequate or 3000, which is clearly very high. Therefore, options might not be the most suitable always.
On the other hand, there is no such restriction with a CFD. You can avail of one to one hedging, which is truly convenient and provides you with the desired cover. There are several other advantages associated with hedging using CFD trading. For example, if you decide to go short with a contract for difference, the broker would be paying you back on a daily basis. This could be an excellent way of hedging your risks in a short position.
Another way of hedging risks successfully is through the contract for difference index. If you own stocks as per a certain index, the wisest thing to do would be to hedge using the index provided, rather than attempt to hedge for every single stock owned. There are several advantages of the same.
First, when you hedge using an index, the brokerage is waived off in most cases. This is a huge plus as you save substantially. Second, the margin is as low as 1% only. This means that you can protect assets worth $10,000 by investing as little as $100. Partial hedging of gold contracts for difference is also an option.
Trading with contracts for difference may be laden with inherent risks however. You need to understand the various mechanisms well before attempting to hedge your risks with the help of these effective financial instruments. Especially, you need to be wary of uncertain periods in the markets.