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How do you control the risks you take in volatile markets?
Volatility is a significant aspect of financial markets, and success in trading requires not only knowledge but also discipline.
In recent months, Dow Jones Industrial Average has broken an 11-year bull run. Closer to home, the Straits Times Index has fallen more than 20 per cent since the start of the year 2020.
Turbulent markets present trading opportunities. But taking a bet in such unprecedented volatility requires an immense appetite for risk or a crystal ball vision on future direction. If a trade has limited downside, taking a position becomes manageable even for the novice trader.
Trading Contract for Difference (CFDs) is one way of taking advantage of market volatility. A CFD trade is an agreement to exchange the price difference of an asset over a period. CFDs are available for a range of underlying assets, including shares, indices, commodities and foreign exchange, and one benefit is that trades are done without owning the asset.
While CFDs allow for profit-making from short-term price swings, like all trades, taking steps to limit risk is critical. IG has brought risk management for CFD trades to a higher level with the introduction of Knock-Outs. Knock-Outs is a CFD product that move one-for-one with the underlying price of the asset and close automatically if the chosen Knock-Out level is achieved. The product enables investors to customise CFD's risks, thereby limiting losses.
Investors pre-determine their maximum loss before trading begins because the Knock-Out level is set before a trade is entered. A caveat is that once the Knock-Out level is set, it cannot be changed during the trade. This restriction helps to instil discipline as it ensures that the risk of a trade is well-considered and not influenced by market noise. With the ability to control risk, the instrument is useful not only for new traders but for sophisticated traders.
There are two types of Knock-Outs: bull and bear.
- You'd buy a bull Knock-Out if you believe the price of the underlying market will rise.
- You'd buy a bear Knock-Out if you believe the price of the underlying market will fall.
A Knock-Out premium is payable if the Knock-Out level is triggered. However, if the position is closed before the Knock-Out level is reached, the premium would be returned to the trader. This premium varies depending on the underlying instrument.
Here’s an example to illustrate how Knock-Out works:
The Wall Street Index is trading at 19,490.
Investor A expects the index to rise.
Investor A buys a "Bull Knock-Out", with a Knock-Out level at 19,290.
The size is set at ten contracts, which means that the trade will move $10 for every point of movement in the index.
If the knock-out premium for the Wall Street index is $5, the initial margin that Investor A has to pay is:
(Price difference X size) X1.1 margin + (Knock-Out Premium X size)
(19,490 – 19,290) x 10) X 1.1 + (10X5) = $2250
1) If the Wall Street index rises to 19,590, the profit would be:
(price gain) X (number of contracts)
(19,590 - 19,490) X10 = $1,000
Investor A's running profit will be $1,000.
2) If the Wall Street index drops to 19,390 the loss would be:
(price drop) X (number of contracts)
(19,490 – 19,390) x 10 = - $1,000
Investor A's running loss will be - $1,000.
3) If the Wall Street index drops to 19,180, triggering the 19,290 knock-out level:
Investor A's realised loss will be -$2050 (including the Knock-Out premium with the 0.1 margin paid back)
Taking advantage of market swings can bring huge profits, but it is essential to have proper risk management strategies right from the start, and instruments like IG Knock-Outs allow traders to do just that. Success in trading requires discipline to protect against losses and not to be swayed by market noise that causes short-term volatility, even if the market is in your favour.
Visit https://www.ig.com/sg/knock-outs to learn more.
IG provides an execution-only service. The information in this article is for general circulation and information 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 carry risks and may not be suitable for everyone. Losses can exceed deposits. This advertisement has not been reviewed by the Monetary Authority of Singapore.