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There is no doubt that markets have been going through a period of great uncertainty. Everyone is keeping an eye on volatility in the markets these days, with many traders feeling apprehensive about risking their money due to the prevailing climate of uncertainty.
To complicate matters even further, new legislation has been passed to increase margin requirements for FX trading from 2% to 5%, which means traders now have to put up more cash when using margin. (These new rules do not affect accredited and expert investors.)
Uncertainty in the markets and higher margins mean that it is now more important than ever to manage your risk properly. IG Knock-outs lets you do just that.
What are Knock-outs?
Investment platform IG has just launched a new limited risk product that lets you manage the amount of risk you take. On the IG Knock-outs platform, you can trade CFDs for forex, indices and commodities. What are knock-outs? Simply put, they are limited-risk CFDs that you can trade while customising your margin and risk.
How does it work?
When trading knock-outs, you have two main options depending on whether you think the market will rise or fall:
- If you think the market will rise, buy a Bull Knock-out.
- If you think the market will fall, buy a Bear Knock-out.
After you have decided what kind of knock-out you would like to buy, you choose the size of your trade in terms of the number of contracts. If you set the size at 5 contracts, that means that your trade will move $5 with every point of movement of whatever you are trading.
You then set your knock-out level, which is the maximum potential loss you are willing to take on. Once your knock-out level is hit, your trade closes automatically.
Cost of a Knock-out
Here are some key costs to consider:
- Spread – This is the difference between the bid and ask price.
- Knock-out premium – This varies depending on the market’s risk and volatility. The knock-out premium is included in the spread but will not be charged if you close the trade before reaching the knock-out level or if the level is not hit.
Let’s take a look at a simple example of how this would work, using the Straits Times Index (STI) for illustration purposes:
The STI is currently trading at an offer price of 3170. You expect the STI to go up based on the release of a quarterly economic report, thus you buy a Bull Knock-out, with a knock-out level of 3155. You set the size at 10 contracts, which means your trade will move $10 for every point movement in the STI. If the knock-out premium for the STI is currently 10, this is the margin you will have to pay:
[Underlying IG price (3170) – knock-out level (3155) + premium (10)] x size (10) = S$250
Let’s see what will happen in 3 different scenarios:
Scenario 1: You are correct in your prediction. The market reacts positively to the economic data and the STI rises to 3185, at which point you close the trade. Your profit is:
[Sell price (3185) – buy price (3170)] x number of contracts (10) = S$150
In this scenario, you get the margin for the knock-out premium back, so the final balance into your trading account is S$250 as your profit is less than the margin you paid.
Scenario 2: The market performs disappointingly and the STI declines to 3160. You decide to close the trade.
[Buy price (3170) – sell price (3160)] x 10 = S$100
You also get the margin for the knock-out premium back in this scenario, and incur a loss of $100.
Scenario 3: The data offers a gloomy forecast and the STI drops to 3148, below your knock-out level. The trade is automatically closed at 3155 and your loss is S$250, including the knock-out premium.
As you can see in the above scenarios, the knock-out ensures that your maximum loss doesn’t exceed the initial margin you pay.
What’s the difference between a Knock-out and a Guaranteed Stop?
Knock-outs and Guaranteed stops are both designed to limit your risks.
When trading IG Knock-outs, you can preset your maximum loss so it does not exceed the original margin you’ve paid. A guaranteed stop helps you manage risk in a similar way by setting a maximum loss amount.
The main difference is that you are able to change your G-stop level whenever you want, but with Knock-outs you lock in your maximum loss at the start so you know beforehand the maximum amount you risk losing.
This helps to instil a good discipline in your trading, and not make changes based on your emotions or market swings. This is especially good for beginners who may not be used to the volatility of markets, and need that sort of rigour to keep them consistent and on track.
How can you use it to help manage your risk?
IG Knock-outs let you decide how much you are willing to lose on each and every trade. You can thus set your trades to ensure your maximum potential losses are within what you can afford to lose.
The stage at which you pick your knock-out level is thus one of the most important steps in limiting your risk. It’s a good idea to have a look at your cash reserves before you begin trading and determine how much you are willing to lose. You can then set your trades accordingly, checking back periodically to monitor your remaining cash.
Trading in volatile markets can be beneficial if you know how to take advantage of swings in the market. But it can also be risky, which is why it is important to know how to control your risk exposure. IG Knock-outs gives you the best of both worlds by providing you with the tools to better manage risk while still enjoying the benefits of trading in volatile markets.
To find out more about alternatives to FX trading, check out IG’s free ebook, which also includes a chapter on Knock-outs.
This advertisement has not been reviewed by the MAS. The information in this article is meant for informational purposes only and should not be relied upon as financial advice. Users may wish to approach a financial advisor before relying on any advice provided by the website to make any decision to buy, sell or hold any investment product. Contracts for Difference (CFDs) are speculative products. The leveraged nature of CFDs involves the risk of losing substantially more than your initial investment.