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In 2020, stock market investors all around the world experienced one of the most volatile periods in recent memory. For example, from 21 February 2020 to 20 March 2020, the S&P 500 declined by more than 30%, from 3,337.75 to 2,304.92.
Since then, the stock markets have rebounded strongly, with indices such as the S&P 500, NASDAQ 100 and the DIJA all trading at a higher price level than at the start of 2020 when we were still in a pre-COVID-19 world. Similarly, major stock indices outside of the US, including TOPIX and the Hang Seng Index, have also climbed above pre-COVID-19 levels.
Since the start of 2021, these major indices have continued performing well and some believe that we are currently in a bull market. Understandably, some investors and traders are concerned that the stock market may decline in the near term.
Whether it’s a short-term price correction or a bear market that could last for a while, it raises an important question. Besides holding to their investments and enduring the price dip, what can investors and traders do when stock markets are declining?
#1 Invest More Into The Stock If You Believe In Its Long-Term Potential
The simple fact about the stock market is that even robust and profitable companies that have increased several folds over the past years, won’t see its share prices rising in a straight line.
Take Amazon (NASDAQ: AMZN), for example. Since 2015, its share prices have increased more than 10 times, from US$308.52 on 2 January 2015 to US$3,159.53 as of 24 February 2021. However, if we were to narrow down to a 5-month period from 7 September 2018 to 28 December 2018, Amazon share prices have dropped almost 30%, from US$1,952.07 to US$1,377.45.
If you were an existing investor of Amazon within the 5-month period indicated above, you would have seen your investment portfolio decline significantly. At the same time, this plunge also represented an excellent opportunity to increase your investment in Amazon.
Of course, this is something we can only say in hindsight. However, the point still stands – if you believe in the value and potential of a company, then short-term dips are actually opportunities to enter.
#2 Sell Your Investments If The Stock No Longer Fits Your Investment Thesis
While investing more in a stock makes sense if you believe in the company’s potential, this isn’t applicable if the initial reasons you invest in a stock no longer holds true.
For example, the COVID-19 pandemic adversely impacted many businesses across sectors such as tourism, hospitality and aviation. While there are some companies from these sectors that could bounce back stronger than before, there will be other companies that may not recover to their pre-COVID-19 performance or even survive.
If you are investing in such stocks, it may be worth asking if it is time to exit some of your investments instead of just “hodling”. Even if these stocks do survive, staying vested in them also comes with an opportunity cost. You could have earned a better return investing in another company if you had realised that the initial reasons for buying the company’s stock no longer held weight.
#3 Hedge Your Investments Via A CFD
For investors who want to leverage on the short-term market volatility, one way to do so is to buy a Contract-For-Differences (CFDs).
While CFDs are commonly seen as instruments traders utilise to make short-term trades, long-term investors can also use CFDs to reduce the volatility they may face during a market dip.
Through a CFD, you can take a short position to hedge against near-term price corrections in your investment portfolio.
For example, if you own $100,000 worth of Amazon shares and the share price dropped by 30% in the next few months, you would incur a paper loss of $30,000. However, if you had hedged your position by taking a short position in Amazon via a CFD, your $30,000 loss in the stock market will be offset by similar gains you make on the CFD.
If you are confident that the price dip is just a short-term correction and that the company will continue performing well in the long-term, you can even use the profits earned from your CFD position to invest in more shares (see point 1).
Do note that CFDs are leveraged products. This means that to take up a position of $100,000, the minimum cash outlay you would require is $10,000 (10% of your trade). You also have to maintain this margin in your account to hold the position. Also, as with all leverage products, the utilisation of leverage is always a double-edged sword. On one hand, if the price movement goes in your favour, your returns will be higher as compared to if you did not use leverage. However, if price moves against you, your losses will also be magnified.
This is why it’s important to ensure sound risk management whenever we trade using leverage.
#4 Buy A CFD To Profit From Market Dips
Besides investing more in quality companies when markets are declining, you can also generate profits by short-selling if you think a company is currently over-valued and would decline in price. Short-selling refers to the selling of a stock that you don’t currently own.
To open a short-sell position, a trader has to borrow the shares from someone (in most case, a broker) who owns it and to sell it to the market. Over the period, if the prediction is right and the price fell, you will close your short position and buy back your shares at the lower price. Hence, if the price declines during the period where your short position is opened, you make profit. If the price increase, you will make a loss.
Besides taking a short-sell position, you can also consider taking a short position in your trade via CFDs if you think that the markets are going to decline, without having to borrow the shares. CFDs allow you to take both long and short positions, which means you can make profits even when prices are declining.
For example, if you think a particular stock or index is currently overvalued and may face a market correction soon, you can take on a short position via a CFD. This way, you can make profits when the price declines. Conversely, if price goes up, you will incur a loss.
When you buy a CFD, you don’t own the underlying asset. Rather, you are entering into a contract with the CFD provider to exchange the difference between the price of an asset when the trade is open and the price of an asset when the trade is closed.
You can also increase your market exposure and thus your potential profits or losses via leverage.
CFDs Provide The Flexibility To Adapt To A Declining Stock Market
Whether it’s to protect your long-term investment positions, take advantage of short-term price volatility on companies you are already vested in, or capitalise on stocks/indices that are potentially overvalued, CFD is an instrument you can consider using to meet specific objectives in your investment strategy.
If you want to consider using CFDs, counterparty risk is an important consideration because you are entering into a contract with the CFD provider, rather than dealing with the underlying asset. You can open an account with IG, the world’s No.1 CFD provider (by revenue excluding FX, June 2020). Opening an account with IG is free and allows you to trade CFDs across various asset classes such as stocks, indices, forex and even commodities.
When you open an account with IG, you gain access to the IG Academy, which offers online courses, live sessions and webinars that you take part in to improve your trading skills. There is also an IG Community where you can meet other like-minded traders to discuss ideas and market opportunities.
For those who are new to CFD trading, it will be advisable to start off with a demo account. The IG Demo trading account allows you to practise CFD trading with $200,000 of virtual funds, giving you the opportunity to get familiarise with the platform you are using and the strategies you want to deploy before you commit money into your CFD trades.