- What is a hedging instrument?
- Instruments to hedge with
- Hedging with CFDs
- What is the best instrument for hedging?
What is a hedging instrument?
A hedging instrument is any financial product that will enable traders to reduce or limit the risk in an underlying asset class, such as cash, shares, commodities, indices and forex. The practice of hedging a market is essentially a way of taking out protective insurance on your trade or investment – it doesn’t prevent risk entirely but can lessen the blow should things go wrong.
To achieve this, a trader will need to open a position on an asset that will become profitable if one of their other positions starts to incur a loss.
Instruments to hedge with
The instrument that can be used to hedge risk is:
- Contracts for difference (CFDs)
The best hedging instrument will depend on its suitability to your trading plan and what you want to hedge. For example, the instrument best suited for hedging forex positions, might vary from the best instrument for hedging bitcoin risk. Ultimately, it all comes down to your personal preference, risk appetite and trading style.
Hedging with CFDs
A contract for difference (CFD) is an agreement to exchange the difference in the price of an asset between when the position is opened and when it is closed. Hedging with CFDs is an extremely common practice as they enable to traders to go long or short on a market, without taking ownership of the underlying asset.
There are a variety of benefits of using CFDs to hedge. For example, CFDs are a leveraged product, which means that a trader only needs to put down a small initial deposit – known as the margin – to gain full market exposure. This gives hedgers the benefit of being able to open more positions and spread out their capital. However, it is important to note that while leverage does enable traders to magnify their profits – as any gains to the position are calculated based on the full exposure, not the margin – it does also create the possibility of magnified losses.
Another benefit of CFDs for hedgers is that traders can offset any losses against profits for tax purposes.1
To get started hedging with CFDs, you can:
- Open an account. You can open an account with IG quickly and easily
- Practise trading on a demo account. Test your hedging strategy in a risk-free environment with an IG demo account
- Develop your knowledge. Join IG Academy to learn more about financial markets
Example of a CFD hedge
Before you can start to hedge with CFDs it is important to known exactly what you’re hedging, in which direction you need to hedge and the position size you need to take.
Let’s look at an example of hedging currency risk. Say you’re a British investment banker working for a US investment bank in London. You’re told at Christmas that you’re going to receive a bonus of $5 million in June, and want to transfer this bonus into sterling. The current rate of cable (GBP/USD) is very favourable, and you don’t want to run the risk of the dollar weakening between now and when you receive this bonus.
You decide to hedge your currency risk with a long CFD trade on GBP/USD – buying the pound, while selling the US dollar. To do this you’d need to work out the position size required to fully hedge your exposure.
Let’s say the current rate of GBP/USD is 1.2800. Firstly, you’d need to convert the amount you want to hedge to the base currency of the relevant currency pair. So, $5,000,000 would give you a £3,906,250 exposure.
One contract of GBP/USD would give you £100,000 exposure, so £3,906,250 would be equal to 39.06 contracts. For CFD clients of IG, one contract of GBP/USD is equivalent to $10 per point, so 39.06 contracts is equivalent to $390.60/point.
Once you’d opened your position, if the dollar weakens against sterling, the profit to the CFD position could balance out the reduction in value of the bonus – however, it wouldn’t be a perfect hedge as you would be exposed to US dollar movements when converting realised profit. If the dollar strengthened against sterling, you would take a loss on your CFD, but your bonus would have increased in value due to the favourable exchange rate.
What is the best instrument for hedging?
The best instrument for hedging will be the one that suits your trading and investment plans to help you realise your financial objectives. Traders will need to be aware of the cost and transparency of the instrument they are using to hedge an underlying portfolio.
CFDs are often considered the best instrument for hedging, as they do not have a contract expiry date – this can be beneficial when longer-term protection is needed. CFDs also have the added benefit of enabling traders to offset their losses against profits for tax purposes.
