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What is CFD Trading?
Contract for difference (CFD) are essentially an agreement or contract between you and your CFD broker. A CFD is a tradeable financial instrument that is priced to mirror that of the underlying asset, allowing for profit or loss to be realised when the underlying asset’s price moves in relation to the open position. CFD’s provide the ability for investors to protect against adverse market price movements or limit the possibility of losing money. This is achieved by opening quickly executed positions that can act as a hedge against other trades such as a large portfolio of corresponding market stocks.
Chinese Factory PMI index results in record low:
Over the weekend China released its manufacturing activity for February, one of the first data points that has been seen since the coronavirus took hold. The news was not good, with the index dropping to an all time low of 35.7 in February, down from 50 in January. This collapse in China’s PMI is so significant that it exceeded the lowest figure during the global financial crisis in 2008, highlighting the severity of the problem that President Xi Jinping has in manoeuvring the world’s second largest economy through the coronavirus threat.
Hedging using the ASX 200 Index Futures CFD’s to Hedge portfolio risk:
Futures indices contracts are one of the most common derivatives used to hedge risk. These CFD’s act as a great low cost, liquid trading instrument.
When considering a hedge, you may be looking at locking in the value of your share portfolio at a specific time. As an example, if you hold a share portfolio that trades similarly to the ASX 200, by selling ASX 200 index CFD’s traders could lock in the value of your portfolio at that particular point in time. If the index falls after the CFD is sold, the stock portfolio will also fall but the losses experienced by your share portfolio will be offset by the profit that is generated by the index CFD position. On the other hand, if the index rises, both the stock portfolio and the CFD position will also increase. The increase in the value of the shares will now offset the losses accumulated by the CFD transaction.
Alternatively, traders can even use index CFD’s to hedge the idea of placing a purchase of shares in the future.
The ASX 200 Index Double Top Pattern that led to the fall:
The chart above displays a double top technical pattern formed between the highs reached in January and February of 2020. The corresponding intervening trough at the highlighted area of 6887 was broken early Monday the 24th of February. This technical signal generally signifies the end of an uptrend and the beginning of a new downtrend, often acting as a lead indicator of a market selloff.
The Benefits & Risks of Trading Index Futures:
Some of the benefits of using index futures as a hedge to a share portfolio are as follows:
One of the key benefits of trading index CFDs is that it provides traders the ability to easily short an index if they believe a market is set to fall. This is simply achieved by entering a short position and having no corresponding long position or long share investments.
What are the risks of trading with CFD’s:
A risk in trading index futures to hedge your portfolio is that your potential for losses could be magnified through the use of leverage risk if the allocation of your position is incorrect. Also, when considering hedging your stock portfolio, your hedge of the index may not be perfectly matched to your current holdings.
The Volatility Index closes above 20:
The chart above displays a higher high on the VIX 4hr chart (highlighted in yellow), exposing the VIX to a break above the 20 level and further increased volatility of the corresponding indices. This break happened at the same time the ASX 200 futures closed below the intervening trough. Often the VIX index can be used as a form of technical cross analysis to help better understand the price movements of the markets.
CFD’s & Hedging:
Hedging a stock portfolio using index CFD’s can be a cost-effective way of quickly entering a position to potentially lock a portfolio price at a specific time. However, it is important to consider the size of a portfolio and whether it moves similarly to the corresponding CFD index before placing a trade. Hedging should not be used as a substitute for a good trading plan, but as a tool to help navigate future price movements.
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