The past year has been a turbulent one for markets worldwide.

After a monumental crash at the beginning of the pandemic, the Straits Times Index has had a bumpy recovery in the first half of 2021, suffering a sudden slump in May and declining for most of June.

The Standard and Poor's 500, which suffered a huge fall in March last year, has since bounced back, but the index's fluctuations have been relatively dramatic.

In a similar vein, after an initial crash in March last year, followed by a year of steady growth, the Taiwan Capitalisation Weighted Stock Index crashed again in May this year on the back of a resurgence in Covid-19 cases.

Market volatility has left many investors wringing their hands, with some holding on to their investments in the hopes of better days. Due to the recent volatility, more investors are turning to derivative products such as contract for differences (CFDs) to try to capitalise on potential opportunities in the current market environment.

What are CFDs?

CFDs are a derivative product pegged to assets such as indices, forex, shares, commodities and more. As the name suggests, derivative products derive their value from their underlying assets. Instead of buying and owning the underlying assets themselves, traders can simply trade on their opening and closing trade prices.

CFD trading differs from traditional stock trading in a few key ways.

With traditional trading, traders are buying a stock in the hopes that its price will rise later on, enabling them to sell at a profit.

When trading CFDs, on the other hand, traders can take advantage not just of rising, but also falling market prices. This can be beneficial when trading in today's highly volatile markets.

Traders profit from price fluctuations by shorting the market, which involves borrowing CFDs and selling them on the market in the hopes of being able to buy them later at a lower price to return to the lender. In doing so, the trader profits from the difference in prices.

Trading in this way offers a chance to make money from falling markets, rather than having to hold onto investments long term until markets rebound.

In order to minimise losses, traders can make use of hedging, a strategy that involves offsetting one's trades with opposite positions. For instance, a trader buying a particular share can also short a CFD with the same share as its underlying asset. If the share price falls, the loss is compensated by the amounts earned from the CFD.

CFDs can also be traded on leverage, which enables traders to boost their market exposure and trade bigger volumes for a small initial capital. When trading on leverage, traders are essentially borrowing money from the broker to multiply the size of their trades.

However, it is important to note that trading on leverage can come with increased risks, since any profits or losses are calculated based on the full size of the position, including any funds obtained through leverage. This means that a trader using leverage to multiply a trade by 10 also risks losing 10 times his or her initial outlay.

How knock-outs limit risks

Knock-outs are a unique product offered by IG that can offer a competitive edge when trading CFDs.

IG is an online trading platform that offers traders access to over 17,000 financial markets including shares, indices, forex, commodities, as well as limited-risk products like knock-outs.

IG's knock-outs act as a powerful risk management tool that enables traders to limit risk while trading on higher leverage with an in-built guaranteed stop.

When trading knock-outs, traders set a guaranteed-stop level, also known as a knock-out level. In doing so, the trader is essentially indicating a pre-selected price at which the trade will automatically be closed. By closing a trade before prices can rise or fall any further, guaranteed-stop levels enable traders to protect themselves from excessive losses in volatile markets.

To trade knock-outs, traders first select a bull knock-out if they predict the market will rise, or a bear knock-out if they anticipate a fall in market prices.

Next, they set their desired knock-out level and trade size. Pricing of the knock-out moves one-for-one with the underlying asset's. In other words, the knock-out moves one point for every point moved by the underlying asset, making trading a simple and intuitive process.

The selected knock-out level is akin to a guaranteed stop that will ensure that the trade closes at the indicated price. The position allows zero slippage, so traders have the assurance that the trade will close at the exact knock-out level they have pre-selected at the start, protecting them from excessive losses. This offers traders peace of mind, even during large market swings.

Knock-outs offer a great way to enjoy unlimited upside while limiting potential losses, enabling traders to profit in volatile markets while managing risk at the same time.

They also have the potential to make short-term trading profitable and can complement the longer-term investments in a trader's portfolio.

IG provides an execution-only service. The information in this article is for informational and educational purposes only and does not constitute (and should not be construed as containing) any form of financial or investment advice or an investment recommendation or an offer of or solicitation to invest or transact in any financial instrument. Nor does the information take into account the investment objective, financial situation or particular need of any person. Where in doubt, you should seek advice from an independent financial adviser regarding the suitability of your investment, under a separate arrangement, as you deem fit.

No responsibility is accepted by IG for any loss or damage arising in any way (including due to negligence) from anyone acting or refraining from acting as a result of the information. All forms of investment carry risks. Trading in leveraged products such as CFDs carries risks and may not be suitable for everyone. Losses can exceed deposits.

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