Managing risk in different market conditions using CFDs

Managing risk in different market conditions using CFDs

With contracts for difference (CFDs) like IG’s Knock-Outs, you can take long or short positions while hedging your portfolio.

Volatility Magnified
With market volatility still in sight, it is crucial to instill proper risk management tools to manoeuvre through different market conditions. Photos: Shutterstock

After a turbulent 2020, much uncertainty remains in the new year as countries around the world seek a path out of the ongoing global pandemic. Investment markets have not been spared from the volatility. On Jan 4 this year, the Cboe Volatility Index, known as Wall Street's "fear gauge”, closed at its highest level since Nov 5, 2020.

Such an unpredictable environment is still expected to persist in the near term at the least. Against this backdrop, investors and traders need to employ instruments to help them manage risk effectively while potentially profiting from trading opportunities that may arise.

THE LONG AND SHORT OF IT

To mitigate risks while capitalising on potential opportunities in the current market environment, savvy traders have been turning to derivatives products such as contracts for difference (CFDs).

A CFD is an instrument that allows traders to speculate on financial markets without having to own the underlying asset. In a CFD trade, a client and a broker both agree to exchange the price difference in the current value of an underlying asset and its value at the end of the contract.

This offers traders the opportunity to make a profit regardless of whether an asset’s price rises or falls, as they are able to take a long position (if they are expecting the price to go up) or short position (if they are expecting the price to fall) on the asset. This ability to go long or short is particularly useful in volatile markets.

As you are able to take short positions, CFDs can also act as a hedge for your portfolio. For instance, if you expect that a physical asset you own will fall in value, you can open a short position in CFD to offset any potential losses.

USING LEVERAGE TO FREE UP CAPITAL

Volatility Sign

Another key advantage of using CFDs is the ability to use leverage to trade, which means that you only have to deposit a fraction of the full value of trade. This deposit is known as a margin. Being able to trade on a margin ties up less of your capital, which can be freed up for other purposes.

However, while leverage enables you to spread your capital further, do note that your profit or loss will still be calculated on the full size of your position. This means that both profits and losses can be magnified compared to your outlay, and that losses may exceed deposits.

As such, margin trading can be risky if a trade goes in the wrong direction. To mitigate losses, traders use risk management tools like stops, alerts and limits. To safeguard your trade better, guaranteed stops are a good measure to ensure that your trade does not fall below the expected risk even during extreme market volatility. A guaranteed stop will only be charged a small fee if triggered.

One provider of CFDs is IG, an institution that has been in the forefront of the trading industry for more than 45 years. In Singapore, IG is regulated by the Monetary Authority of Singapore, and has been supporting traders here since 2005.

KNOCKING OUT RISKS

IG’s latest CFD product, Knock-Outs, offers a unique feature that comes with an in-built guaranteed stop that can be traded on a range of underlying assets, including FX, commodities, equities and indices.

Knock-Outs mitigates risk by allowing you to determine the exact price you would like your trade to close by setting your Knock-Out level at the start.

The Knock-Out price moves one-to-one with the underlying price of the asset and you only pay for the stop if it is triggered. The Knock-Out level acts like a guarantee that closes out your trade even during times of huge market swings.

Bull Bear

For example, if you believe that the market price is going to rise, you could buy a bull Knock-Out and set a Knock-Out level below the opening market price at which your position will be closed if the market goes against your expectations. 

Here’s an example. If you think the Straits Times Index (STI) is going to increase from its current level of 3,000, you can choose to buy a bull Knock-Out, with a Knock-Out level of 2,970. If you set the size of the trade at S$10, this means that your trade will move S$10 for every point that the index moves. If the premium is set at S$2, the maximum amount you can lose is calculated as follows:

[Current Price (3,000) – Knock-Out Level (2,970) + Premium (2)] x Size (10) = S$320

This is a critical advantage in an erratic market, where rapidly moving asset prices might lead to a phenomenon known as gapping. Gapping occurs when a stock or other trading instrument opens above or below the previous day's close with no trading activity in between. This can cause traders to lose more than they expect.

With market volatility still in sight, it is crucial to instill proper risk management tools to manoeuvre through different market conditions. Seek market opportunities with Knock-Outs to:

  • Go long or short in bull or bear market conditions.
  • Access markets like 24/7 indices, commodities, FX and equities.
  • Hedge your current portfolio.
  • Know your maximum risks taken right at the start. This can also serve as discipline for traders as a pre-set Knock-Out level means that you will not be swayed by mercurial market conditions.

Visit ig.com/sg to open an account to trade Knock-Outs.

Disclaimer: IG provides an execution-only service. The information in this article is for informational and educational purposes only and does not constitute (and should not be construed as containing) any form of financial or investment advice or an investment recommendation or an offer of or solicitation to invest or transact in any financial instrument. Nor does the information take into account the investment objective, financial situation or particular need of any person.  Where in doubt, you should seek advice from an independent financial adviser regarding the suitability of your investment, under a separate arrangement, as you deem fit.

No responsibility is accepted by IG for any loss or damage arising in any way (including due to negligence) from anyone acting or refraining from acting as a result of the information. All forms of investment carry risks. Trading in leveraged products such as CFDs carries risks and may not be suitable for everyone. Losses can exceed deposits.

This advertisement has not been reviewed by the Monetary Authority of Singapore.

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