This article was written in partnership with IG, the world’s No.1 CFD provider (by revenue excluding FX, February 2018).
2018 has been a poor year for most investors. At the start of the year, the benchmark Straits Times Index (STI) was trading at 3,489. As of 5 November 2018, it’s down to 3,060, a decline of 12.3%.
As a consequence, many investors in Singapore would have seen a similar decline in their investment portfolio. If they haven’t already, some investors may be contemplating selling off all or part of their investments in order to prevent further losses.
When markets are doing well and market sentiments are strong, people tend to be bullish in whatever it is they are investing into. However, when markets start facing headwinds, the same investors start to procrastinate and wonder how they should change their investment strategy.
Typically, most investors would consider three options during a market slowdown.
Option 1: Do nothing (That’s what all the value investing gurus say you should do)
Option 2: Panic and start selling their investments. Not advisable. Here’s why you should not panic when you lose money in the stock market.
Option 3: Invest more. Easy to say but much more difficult when it comes to forking out actual cash, especially when you are already seeing your portfolio decline by a significant margin.
What most investors do not know is that there is a fourth, less frequently used and slightly more complex, option. You can buy a Contract for Difference, or more popularly known as a CFD, to hedge your current position and support your investment portfolio.
What Are CFDs?
CFDs are a type of derivative. In finance, derivatives are assets with a value that is derived from other underlying assets.
CFDs are contracts between two parties to exchange the difference between the price of an asset from its opening position to its closing position. By using a CFD, you can trade on the price of any assets in the financial markets that you want, as long as there is another party willing to be your counterparty (i.e. the party who is willing to take the opposite position of the position you want to trade).
Here’s an example. Suppose the STI is trading at 3,040 points today and you think it will continue declining, you could buy a short position via a CFD on the index. What this means is that if the price falls below 3,040, you will make a profit. Conversely, if it climbs above 3,040, you will make a loss.
To put it simply, a CFD is just another way of entering the financial market without having to own the underlying assets. You can profit (or make a loss) just based on the price difference of an asset without having to actually own it.
Who Should Trade CFDs?
Different asset classes work differently. Hence, even though the concept of CFDs applies similarly across different asset classes (i.e. you pay the difference between the price at opening position and at closing position), the underlying assets that determine the value and volatility of the CFDs can be drastically different.What this means is that, in our view, you should only be trading CFDs into asset classes that you are already familiar with.
Regardless of which asset classes you trade, all CFDs have two main features.
# 1 Able To Go Long AND Short
Unlike when you purchase regular stocks, where you make money only if its price increases, CFDs allow you to take a short position as well. A short position means that you are speculating that the price of the asset will decline in the future. If this happens, your CFD position earns you money. Alternatively, if the price of the asset increases, your CFD position will cause you to lose money.
Of course, you can also go long on CFD positions. This way, your returns simply mimics buying the underlying assets, that is earning a profit when the price of the asset goes up and losing money when the price of the asset declines.
# 2 Able To Leverage Positions
With CFDs, you are also able to leverage on your position. Leverage allows you to magnify your exposure size for the trades that you make without having to commit to the full cost of the position. However, you are still responsible for the entire losses that your position incurs.
For example, a 1% increase in stock price would be a lot easier for a trader to capture compared to a 10% increase. With no leverage, a trader who takes up a $10,000 position would only be able to earn $100 from capturing a 1% gain in a trade.
With the use of a 10:1 leverage through CFDs (available through IG), the same trader would be able to take up a position size of $100,000 and make $1,000 through the trade, thus giving him a 10% return. On the flipside, if the market goes against his position, the losses will also be magnified.That’s why the use of leverage requires prudent risk management.
You can also watch a video where we tried to explain what risk management is, by to the concept of baking.
Using CFDs To Hedge Long-Term Positions
Even as a long-term investor, CFDs can still be beneficial for your overall portfolio if they are employed in the right situations.
When you are investing for the long-term, you would encounter diverse market conditions, including occasional economic slowdowns. During these periods, your investment portfolio is unlikely to gain very much, if any at all. For most investors, this is a time to simply wait out and do nothing.
Due to the fact that investors are not bullish on their positions but see a low probability in significant drawdowns in market value, one other thing they can do is to hedge their portfolio against the risk of their stocks that may decline significantly, without having to liquidate their holdings.
By buying a short CFD position for the same underlying stocks or indices that they already own, investors can offset unexpected losses sustained in their investments during these periods of market slowdown through the gains made on their CFDs.
CFDs do not have expiry date. Hence, when you are more confident about the companies’ future, you can close your CFD position and enjoy the future gain that the stock makes.
Before you purchase a CFD, do note that CFDs are not free. Aside from the contract spread that you pay, there may also be finance charges for CFDs.
Besides that, the credibility of the broker that you use is extremely important, since any contract that you make is ultimately with them, as you will never own the underlying assets. As such, you should only deal with companies that are established, trustworthy those you are familiar with.
If you are looking for a CFD provider, you can consider IG. IG is the world’s No.1 CFD provider (by revenue excluding FX, February 2018). The company is licensed by the Monetary Authority of Singapore and has a shopfront, so you can physically head down to their office and seek assistance if you need some. You can also find out more from IG about how CFD trading works from their extensive step by step free online courses, webinars and live seminars. Start off with a demo account if this is the first time you are using it.
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