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Hedge Your Share Trades With CFDs

by: wanitadof on Date: Fri, 29 Oct 2010 Time: 11:16 PM

CFD trading or Contracts for Difference trading is transacted in a financial market with an agreement between a buyer and a seller. The contract is to exchange the difference in value between the opening and closing of the contract of a particular financial instrument. Thus, CFDs are financial derivatives with greater flexibility than normal share trading. They broaden the trader's horizon as he can go long or short on shares, forex and other financial markets without the need to own the underlying shares.

Benefits

CFD trading on margin provides the trader with leverage. It allows one to invest a small deposit as a lever to borrow and access a large equivalent quantity of assets. The margin requirements of CFDs are low. Taking large positions is possible with only a small amount of money. There is no commission for share contracts traded at the market bid-offer price and for forex traded at spot prices.

CFD Providers

CFD providers are required to engage in CFD trading. A broker or market maker defines the contract terms, the margin rates and the underlying instruments available to trade. Direct market access guarantees trading that matches the price of the underlying instrument in the market. This works well for share contracts but may be more expensive as the provider has to cover the exchange transaction fees.

Corporate Actions On Equity Based Cfds

The contract reflects any economic effect of a corporate action such as dividends, stock splits, rights issues on the underlying asset. A person holding a CFD position will not receive the dividend payment from the company. However, the CFD provider pays the equivalent of the dividend to anyone holding a long position and deducts it from anyone holding a short position. The contract holder has no access to non-economic corporate actions such as voting rights.

Risks

Market risk is high in CFD trading. Margin trading involved in this drives one to speculate movements in financial markets or hedge existing positions elsewhere. Use of stop loss orders can control the loss. Liquidation risk results when extra variation margin is required to maintain the margin level in fast moving markets. With non-availability of funds in time, the provider closes or liquidates the positions at a loss for which the other party is liable. Counterparty risk is very common in most over-the-counter traded derivatives. If the counterparty fails to meet financial obligations, the investor incurs losses, even if the underlying instrument moves in positive direction.

Management

Analysis and an up-to-date knowledge of the market are very crucial before taking a position. Monitoring open positions are crucial. Use of stop orders restricts the possible potential loss. This closes positions at a specified level if the market moves against the trader. A limit order also triggers closing of an order once the market reaches a pre-specified level.

Analysis of market volatility is the key to success in trading. An effective risk management strategy can help avoid substantial losses in the financial market. Understanding fundamental and technical aspects of the market before taking a position help a trader benefit from both rising and falling markets with forex and CFD trading.

About the Author

Trading CFD require an understanding of risk and portfolio management. CFD trading are a leveraged product and can result in losses that sometimes may exceed the initial deposit of the trader.

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