Here’s how you can use Knock-Outs in your investment strategy
IG Singapore has launched its newest limited-risk CFD product, Knock-Outs, which can be a good option for investors who are either new to CFDs, or would like to trade into different asset classes through CFDs. At present, the product is available for trading major forex pairs, stock indices, and selected commodities.
The greatest differentiation between Knock-Outs and other typical CFDs, lies in its ability to limit investors’ maximum potential loss to their initial margin payment.
Here’s how it works.
How to trade Knock-Outs
Knock-Outs are traded based on the direction that an investor thinks the market is going to move and can only be bought and not sold.
If an investor was bullish about the GBP/USD currency pair, he would buy a bull Knock-Out, where the Knock-Out level is below the current underlying price. However, if that investor was bearish about the currency pair, he would buy a bear Knock-Out where the Knock-Out level is above the current underlying price.
A Knock-Out level will be set upon placing the trade, this serves as the guaranteed level where the trade would be closed if the market moves against the investor and hits the Knock-Out level.
Here’s how the price of a Knock-Out is calculated.
Knock-Out Price = Difference between the underlying IG price and Knock -Out level + Knock-Out premium
Knock-Out premiums are calculated based on the risk and volatility of that particular market and is charged upon the opening of the trade position. It is returned to the investor if the knockout level is not breached when the trade is closed.
So if an investor bought 10 contracts of the GBP/USD pair – valued at US$1 per contract – at the underlying IG price of $1.283, with a bear Knock-Out at $1.290, this is his maximum potential loss on this trade.
Maximum potential loss = (12900.0 – 12830.0 + 2) x US$10 = US$720
And the margin for the trade is calculated as such:
Margin required = US$720 x 1.1 = US$792
How Knock-Outs protect investors
Knock-Outs can protect investors from sudden changes in the prices of the underlying asset.
For instance, the announcement from European Commission President Jean-Claude Juncker and UK Prime Minister Boris Johnson on a Brexit deal on Oct 17 resulted in a rapid surge to the GBP/USD, and trading Knock-Outs would have protected bearish GBP/USD investors from the pound’s sudden increase.
Within a day, the pound jumped to a 5-month high against the US dollar on Oct 17, reaching close to US$1.30 by 11am UK time.
However, it fell shortly after, stabilising at US$1.28 by the end of the day, after the Democratic Unionist Party (DUP) announced that they would not support the deal in parliament, a decision that could cause the Brexit deal to fall through once again and result in another tumble for the pound.
In this situation, the investor would have been protected against the sudden spike because of the Knock-Out, and limited his losses to his initial margin payment.
“Over and above the limited risk feature that is nifty in gauging the risk-to-reward ratio for your trades, Knock-Outs come at a time when we are seeing added volatility in the market,” explains IG market analyst Pan Jingyi. “Being able to trade while managing this risk with Knock-Outs can be strongly advantageous.”
How Knock-Outs can be used in your trading strategy
While Knock-Outs appear simple to understand, they can be a very powerful tool in your investment portfolio.
For instance, investors can simultaneously hold multiple Knock-Out positions on the same asset, each with different Knock-Out levels and trade sizes, so some positions can be held for a longer period of time, while others could be designed to manage your risks quickly amid volatility.
Knock-Outs, which are fixed once a trade is opened, can also be used with regular stop loss orders that can be amended at any time. This trading strategy is known as a double stop loss.
In the chart below, the investor is trading the Spot Gold Bear Knock-Out. The Knock-Out level is fixed at 1494, and the investor has chosen to set a stop loss level at 1487.27 and a limit at 1387.9. IG’s powerful position preview allows investors to visualise their trade position as well as their risk/reward ratio, which is 1:2.4 in the chart below.
If the spot gold price falls to 1387.9, the position is closed and the investor makes a profit of US$700. If the spot gold price moves against the investor and reaches the stop loss level of 1487.27, the position is closed with a loss of US$300, without triggering the Knock-Out or incurring the Knock-Out premium. If the market moves against the investor and gaps past the knock out level of 1494, the trade is closed at exactly 1494 and investor makes the maximum loss of US$361.
The regular stop-loss can also be used to take profit when the market has started to move in the investor’s favour. In the chart below, the investor is trading the Spot Gold Bull KO and the spot gold price has started to move ahead of the opening profits. In order to lock in profits, the initial stop loss is adjusted upwards above the opening price. Even if the market starts to reverse its upward trend, the investor is still able to recognise the gains already made in the trade.
Knock-Outs with technical analysis charts
So how can you use knockouts with your favourite technical charts?
Let’s say you’ve spotted a symmetrical triangle breakout, as shown below.
US Crude Oil is currently trading at 5499.4, and the investor expects the price to rebound within the symmetrical triangle pattern. As such, he buys a bull Knock-Out at 5480.
What if you observe an emerging new market trend?
In this case, the investor expects the US crude oil price to fall further from its current 5223.9 price. So he buys a bear Knock-Out with a Knock-Out level at 5460, and adds a limit at 4759.8 with the intention of closing the trade with a profit of US$2,300.
The costs of trading Knock-Outs
Investors should take note of the three key costs to trading Knock-Outs: the Knock-Out premium, the spread, and the overnight funding charges.
The Knock-Out premium is variable. It may increase if market volatility increases, and it may decrease if market volatility decreases. It could also change when investors have an open position, making your Knock-Out worth more when the premium increases, and vice versa.
Spreads are also subject to change in volatile markets, and are equivalent to the underlying IG market spreads.
Overnight funding charges (or daily interest adjustments) are incurred when holding a leveraged position beyond a specified cut-off time every day. They are calculated as shown below:
Daily interest adjustment = Bet size x Underlying index price at 10pm (London time) x Applicable annual interest rate/365
Get started on Knock-Outs
If all this has given you ideas of how you can add Knock-Outs to your trading strategy, you can start trading them right away on the IG trading platform if you are an existing IG customer. Otherwise, you can find out how to open an account with them here.
To learn more about Knock-Outs, you can also download the new e-book written by Bloomberg – “Alternatives to FX CFD trading”. The e-book will offer more details and tips on how investors can utilise Knock-Outs in their investment strategies and other alternatives to FX trading.
If you need to try it out to believe it, you can even practice trading Knock-Outs with a no-obligations demo account from IG today. Get started here.