CFD trading presents tremendous possibilities to profit in the financial markets, but it also carries substantial risks because of leverage and volatility. The question that every serious trader has is: "How to minimize those risks without putting a crimp in profit potential?"
The answer is hedging, which is the more sophisticated risk management strategy virtually all professional traders and institutional investors employ. Think of it as insurance for your trades. Similar to insuring your car to protect you from accidents, hedging protects your trading portfolio from adverse effects of market movements.
Hedging is not speculation, it is not figuring out how to beat the market; it is a well-planned and executed risk management strategy that can help to protect your capital during erratic market conditions. Professional traders know that simply profiting is not the end goal, it's protecting those profits and minimizing losses during times when the markets do not move in your favor.
Take this scenario between you and during the market crash in March of 2020, those traders with hedged positions severely limited their risk, while those hedged positions were taking massive losses; and you clearly see the protective power of proper hedge strategies.
What Does Hedging Mean
Hedging is a way to minimize the risk of adverse price changing by taking offsetting positions in related securities. In simplistic terms, it is opening a position that moves in the opposite direction to your original trade (the main trade), creating a buffer against losses.
A simple analogy would be to say that it's like a high school student who plans to go out on the weekend but is worried that it might rain, so they bring an umbrella as a precautionary measure. The umbrella is the hedge. It doesn't mean the student will definitely not have sunny weather, but it will protect the student if the conditions are suboptimal.
If you are long the S&P 500 index CFD, you might establish a short on a corresponding ETF or correlated index to hedge your original position. This creates a position with offsetting moves that limits both your potential losses and gains.
Hedging vs. Corporate Hedging: Understand the Difference
Corporate Example: A well-established airline takes a hedging position on its fuel costs by purchasing some oil futures contacts to lock in fuel prices for the next 12 months. The airline know that its operating cost will be known and predictable (regardless of fluctuations in the oil price) based upon its purchase of futures contracts.
Trader Example: A CFD trader shorts gold (a direct short) while long on a position on some relevant mining stocks. The CFD trader acts in this way to hedge against an unpredictable gold price for a short period of time during earnings season.
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