This article was written in partnership with IG, the world’s No.1 CFD provider (by revenue excluding FX, February 2018). All views expressed in the article are the independent opinion of DollarsAndSense.sg
Today, IG Singapore announced the launch of a new product – Knock-outs, a type of derivatives that investors and traders can use to make trades for a range of products including foreign exchange (forex) pairs, commodities and stock indices. It’s worth noting however, that knock-outs are not a new product in the financial world.
How Does Knock-Outs Work?
From an investing and trading standpoint, knock-outs are like buying limited risk CFDs. The value of the product you buy (from the brokerage firm) is dependent on the price level of the underlying asset that you are trading, and which side of the trade you are on. You can only buy, and not sell, a knock-out.
For example, if you are trading indices and you think that the price of the index is going to go up, you can buy a Bull knock-out. When prices increase, you make money. If you think prices are going to go down, you can buy a Bear knock-out. And if prices decrease, you will make money. The difference between the price at the time you buy the knock-out and when the knock-out position is exited will be your profit (or loss).
As explained by IG, knock-outs are basically Contracts For Difference (CFD) with an expiry. Unlike regular CFDs, knock-outs have an in-built mechanism to limit how much a trader can potentially lose on each trade.
When a knock-out trade is made, the trader will set a knock-out level, which will be below the current market price of the asset if it’s a Bull knock-out (or above the current market price for Bear knock-out). Think of this like a stop-loss level.
If the asset reaches the knock-out level, the trade position will automatically close and the trader will incur the loss, plus a small knock-out premium. The knock-out premium is only payable if the knock-out is triggered. Otherwise, the premium will be returned back to the trader.
Trading Example: If you think the Straits Times Index (STI) is going to increase from its current level of 3,100, you can choose to buy a Bull knock-out, with a knockout level of 3,070. If you set the size of the trade at $10, this means that your trade will move $10 for every point movement in the index. If the premium is at $2, this means that the maximum risk amount you can lose will be as follows.
[Current price (3,100) – knock-out level (3,070) + Premium (2)] X Size (10) = $320
What determines this maximum risk amount is 1) the current price vs the knock-out level that you set, 2) the premium which will vary depending on the volatility of the market that you are trading and 3) the size of the trade (i.e. how much you want to stake on each point of movement in the market).
If you trade a knock-out through IG, the minimum margin required will be the maximum risk amount multiplied by 1.1 = ($320) X 1.1 = $352.
Advantages Of Knock-Outs
Limited Loss: When trading via a knock-out, regardless of what happens to the market, whether it’s a sudden market crash or spike in price, your maximum loss cannot exceed the initial margin you pay. You will always have full control over the maximum amount of money that you can lose on each trade.
Unlimited Upside: While your downside for knock-out trades are limited, how much you are able to profit from the trade isn’t. This is good because it means that if you have a trading strategy which would regularly spot the right price movement for assets that you are trading, you would be able to let your profit ride out (when you are right) while concurrently limiting your losses (when you are wrong).
Able To Trade Multiple Products: Knock-out trading is a tool that can be used to trade a variety of products. Besides indices, you can also use it to trade currency pairs for forex as well as different types of commodities.
Knock-Outs Are A Good Way For Those Who Are New To CFD Trading
Because they help you to manage the risk taken on your trades, knock-outs are a good way to get started for anyone who is new to trading, or who are buying CFDs for the first time. With knock-outs, traders do not have to worry about losing more than their initial margin or losing more money during slippages, where we get a different price than the expected market price when we execute an entry or exit from a trade.
It’s important to remember that knock-out trading is by itself just a tool that can be utilised for trading. Ultimately, whether you are profitable in your trades over the long-term will depend on how familiar you are with the products that you are trading – forex, indices or commodities – and how refined your trading strategies are.
If you would like to find out more about knock-out trading, or would like to open a trading account so that you can start trading knock-outs in Singapore, you can open an account with IG today. If you are already an existing IG account user, you should already be able to find knock-out on the IG platform.
To learn more about alternative ways such as knock-out trading to access the market beyond Forex, you can download a free eBook published by Bloomberg about trading here.