Knock-outs: The latest CFD product in Singapore for investors who want to control their risk
You might be familiar with CFDs (Contracts For Difference), but have you heard of knock-outs? Knock-outs are the latest limited risk CFD product in Singapore being offered by IG. They are available for trading major forex pairs, stock indices and selected commodities.
While they are traded through CFDs, they are slightly different than typical CFDs as investors merely trade based on the direction that they think the market is going to move.
Explainer: What are Knock-outs?
Knock-outs offer investors full control over their own risk and exposure. That means, an investor’s maximum potential loss with knock-outs can only be as much as his initial margin payment.
Here’s how it works.
Say an investor thinks the S&P500 is going to go up, they can buy a bull knock-out, where the knock-out level is below the current underlying price. In that way, the knock-out level protects the investor when the market moves against them.
Likewise, if the investor thinks the S&P500 is going to go down, they will buy a bear knock-out where the knock-out level is above the current underlying price and will be protected when the market goes up.
What are the costs of trading Knock-outs?
This should be the question on every savvy investor’s mind when introduced to a new investment product, and IG has made their fees very transparent.
There are three main costs of trading knockouts.
- The spread – or the difference between the bid and ask price
- Overnight funding charge – these are incurred for leveraged trades held pass the cut-off time every day
- Knock-out premium – The knock out premium protects investors from slippage on their selected knock-out level, and are calculated based on the risk and volatility of that particular market. It is charged upon the opening of the trade position, and returned to the investor if the knockout level is not breached when the position is closed.
This is the formula for determining the price investors pay for a knock out.
Knock-out Price = Difference between the underlying IG price and Knock-out level + Knock-out premium
Limited losses for better risk management
The beauty of knock-outs is that investors’ downside risk on each trade is limited to the initial margin that they allocate for the trade.
Margin = Opening KO price x Size of trade x 1.1
Here’s how it works in a trade.
Going back to the investor who wants to trade the S&P 500, he could choose to trade knock-outs CFD on the “US 500 Bull Knock-Out or a “US 500 Bear Knock-Out”, which follows the S&P 500 index.
Assuming the current price on the US 500 is 2,910.6, and the investor expects it to rise, he might buy a bull knock-out position that moves $5 per point with a knock-out level of 2710.6.
In this case, with a knock-out premium of 0.25 points, here is his maximum risk on this trade.
(2910.6-2710.6 + 0.25) x $5 = $1001.25
And this is his minimum margin
$1001.25 x 1.1 = $1101.38
The trade is closed in 3 ways: upon expiry of the knock-out, when the knock-out level is reached, or when the investor closes the trade before the expiry or a knockout.
If the S&P 500 really moves in his favour, and the investor closes the trade when the bid price reaches 3010.6, this is how his profit is calculated.
(3010.6 – 2910.6) x $5 = $500
If the S&P 500 falls, and the investor closes the trade at the bid price of 2810.6 (before it reaches his knockout level), his loss would be this.
(2910.6-2810.6) x $5 = $500
What if the S&P 500 gapped to a price of 2650? His trade would be closed at his chosen knock-out level of 2710.6, and his loss would be the maximum risk we calculated earlier at $1001.25.
Who should trade knock-outs?
From the example above, it is clear that knock-outs are good for investors who want to limit their downside risks in a CFD trade.
On top of that, knock-out pricing is simple to understand, as it moves one-for-one with the underlying IG price. It provides the flexibility for investors to decide their risk while providing the assurance that losses are limited to their margin. This also help to instil discipline in the investor as they are unable to change the levels of their knock-outs and not be wavered by any trading psychology.
The simplicity of knock-out trades – as investors only trade long in a single direction per trade – also makes it easy for new investors to test their trading skills with.
As such, it would make a suitable product for investors who are new to CFDs, or investors who want to try investing in a new asset class that they may not already be familiar with.
It is also useful for investors who need to hedge their short positions.
At the same time, it is important for investors to note that knock-out levels are fixed once a trade is open and can only be changed after the trade is closed. Spreads also vary throughout the day, depending on the trading hours of other markets.
Four steps to start trading knock-outs
- To start, you will need to open a CPF account with IG. Knock-outs are available on IG’s trading platforms and their mobile apps.
- Choose a bull or bear knock out
- Set your knock out level
- Open your position
Learn more about Knock-outs
If you would like to learn more about IG’s new offering, you can 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
You can also try out knock-outs with a demo account from IG today. Get started here.