Advantages Of Trading In Volatility With CFDs Compared With Regular Trading
A contract for difference is a form of derivative that allows traders to take a position on the rising or falling of prices an asset. It is a tradable contract between a client and a broker who agrees to exchange the price difference in the current value of an underlying asset and its value at the end.
This form of trading allows traders to benefit from price movement without having to own any underlying asset.
A Primer: How CFDs Work
When it comes to trading CFDs, you don’t buy or sell the underlying asset. Instead, you buy or sell a number of units for a particular asset, depending on whether you think prices will go up or down. This form of trading can be carried out on a number of markets including shares, treasuries, currency pairs, commodities and stock indices.
While trading CFDs, two sets of prices based on the underlying asset are typically offered:
Buy Price: The price one has to pay in anticipation of the price of the underlying asset rising. The price is usually higher, and one only benefits on the asset becoming more valuable on the final price being much higher than the buy price.
Sell Price: The price one pays while expecting the price of the underlying asset to drop. Given that, it is usually lower than the market price, one only profits on the asset becoming less valuable on the price dropping.
The difference between the buy and the selling price is called the Spread.
CFDs can be traded on leverage, for which traders are allowed to put up only a portion of the total value of a trade to open a position. For instance, a trade of SG$1000, one might be allowed to use SG$50 to trade.
Leverage allows traders investments to go much higher. However, this would also mean that the risk might also go higher which could lead to losses accruing much faster.
So now that you are more familiar with CFD trading, how can investors benefit from CFD trading during times of volatility?
Benefits of Trading CFDs on Volatility
Volatility is a measure of uncertainty. An asset with high volatility has a higher potential of its price ranging as compared to that of a low volatility stock. For example, an asset trading at $100 with an implied volatility of 25%, will mean that its price could be higher or lower by 25% on one standard deviation.
·Trading wherever opportunities lead
Contract for differences allow one to trade a wide range of markets, some of which are usually extremely volatile. Shares of companies’, indices, commodities, forex, cryptocurrencies and options are some of the most popular instruments in this case.
Some trading platforms allow traders to trade outside trading hours, which makes it possible to make the most of company’s announcements before and after hours of trading.
For example, IG allows investors to trade over 15,000 markets, including 24 hour trading for global indices.
·Leveraging your capital
Unlike regular trading where one buys an asset directly, CFD trading allows one to use leverage in a bid to enter positions that under normal circumstance would require a lot of money. With leverage, you only need to deposit a fraction of the full value of an asset to open a position.
The deposit that you will have to put down to trade price movements is called margin. How much you need to deposit depends on the size of the position you need to open as well as margin factor for a given market. While this form of derivative trading allows you to maximise the use of your capital, you should also note that losses can result in losing your entire capital or more.
IG offers a tiered margining policy, so smaller trade sizes would enjoy the lowest margin rates. Tiered margining helps by giving traders the best fit for the size of their position in a particular market. The margin rate will increase progressively as your aggregate position moves up from one tier to the next. For example, if an investor purchased less than 70,000 shares in CapitaLand, he would enjoy a 10% margin. If the same investor chose to purchase between 70,000 to 700,000 shares, he would incur a 20% margin on the portion that falls beyond the lower tier.
·Trading no matter which direction the market is going
In regular trading, it is not possible to enter a short position on an underlying asset. However, with CFDs, you can bet on the price of an underlying asset dropping. This form of derivative trading thus provides a way of investing in markets that are in a downtrend.
Going short on CFDs is made possible by the fact that there is sell price that allows one to enter a position assuming that the underlying asset will become less valuable with time. This way one is able to make money while the market is dropping. Similarly, if the market is expected to go up, going long using CFD can allow one to profit during such market conditions.
On top of that, some CFD providers, like IG, offer stops like ‘Guaranteed Stop Loss Orders’ (GSLO) which prevents investors from any rude shocks in case a stock price gaps through a stop loss. These GSLO do not incur any premium until it is triggered.
·Extended Trading Hours
CFDs make it possible to trade volatile financial instruments at any given time regardless of where one is. With most trading platforms dealing in CFDs, one is usually not restricted to normal trading hours. As highlighted above, IG offers 24 hours trading on global indices, allowing your trades to be placed at a timelier manner.
·Direct Market Access Advantage
When it comes to trading in regular market one usually buys an asset depending on the price a broker is offering rather than what might be happening in the market. However, with CFDs, one is generally able to interact with order books of stock exchanges and forex, through a direct market access (DMA) broker.
Instead of having to pay what a broker is offering, an investor would be able to see the various bid prices and thereby trade at the market price of their choosing. This greater transparency allows traders to consider market liquidity which can minimize the risk of positions being rejected.
IG is a DMA broker, giving investors the ability to view market depth and trade directly into the order book helping them gain better market visibility and flexibility.
·Use CFDs as a Portfolio Hedge
CFDs act as a useful hedging tool when the markets are extremely volatile. For example, if you are holding a stake in Company Y for long term price growth, and you anticipate a price decline in the short term, you could take an opposite position of your portfolio in shares CFD to offset any portfolio risk.
Investing in the Chicago Board Options Exchange’s (CBOE) Volatility Index (VIX) – better known as the stock market’s “fear index” – is another method of hedging volatility through CFDs.
The premise of the VIX is this: investors who are more fearful of sudden changes in stock prices would be more willing to pay higher prices for options that guard against those stock price changes. That is why the VIX tracks the prices on the options market, not on the stock market.