In 2021, stock market investors all around the world knowledgeable of the most volatile periods in recent memory. For example, from 21 February 2021 to 20 March 2021, 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 like the S&P 500, NASDAQ 100 and also the DIJA all trading at a higher price level than at the start of 2021 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 plus some believe that we are currently in a bull market. Understandably, some investors and traders are concerned that the stock market may decline soon.
Whether it's a short-term price correction or perhaps a bear market that could last for a while, it raises an important question. Besides holding for their investments and enduring the cost dip, what can investors and traders do when stock financial markets are declining?
#1 Invest More In to 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 inside a straight line.
Take Amazon (NASDAQ: AMZN), for example. Since 2021, its share prices have increased more than 10 times, from US$308.52 on 2 January 2021 to US$3,159.53 as of 24 February 2021. However, when we were to narrow down to a 5-month period from 7 September 2021 to 28 December 2021, Amazon share prices have dropped almost 30%, from US$1,952.07 to US$1,377.45.
If you had been an existing investor of Amazon inside the 5-month period indicated above, you'd have seen your investment portfolio decline significantly. Simultaneously, this plunge also represented an excellent opportunity to increase your investment in Amazon.
Of course, this really is something we can only say in hindsight. However, the point still stands – if you believe in the value and potential of the company, then short-term dips are in fact opportunities to enter.
#2 Sell Your Investments If The Stock No Longer Fits Neglect the Thesis
While investing more in a stock makes sense if you believe in the company's potential, this is not applicable if the initial reasons you purchase 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 may bounce back stronger than before, you will see 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 for you to exit some of your investments instead of just \”hodling\”. Even if these stocks do survive, staying vested inside them also comes with an opportunity cost. You could have earned a better return investing in another company if you had realised the initial reasons for buying the company's stock no longer held weight.
#3 Hedge Your investment funds Via A CFD
For investors who want to leverage around the short-term market volatility, one way to achieve this is to buy a Contract-For-Differences (CFDs).
While CFDs are commonly seen as instruments traders utilise to create short-term trades, long-term investors can also use CFDs to lessen the volatility they may face during a market dip.
Through a CFD, you are able to 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 also 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 situation 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 are making on the CFD.
If you are certain that the price dip is just a short-term correction which the company will continue performing well within the long-term, you can even use the profits earned from your CFD position to invest in more shares (see point 1).
Do observe that CFDs are leveraged products. Which 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 might also need to maintain this margin in your account to hold the position. Also, as with every leverage products, the utilisation of leverage is always a double-edged sword. On one hand, when the price movement goes in your favour, your returns is going to be higher as compared to if you did not use leverage. However, if price moves against you, your losses may also be magnified.
This is why it's important to ensure sound risk management once we trade using leverage.
#4 Purchase a CFD To Profit From Market Dips
Besides investing more in quality companies when financial 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 back to the selling of a stock you don't currently own.
To open a short-sell position, an investor has to borrow the shares from someone (in many case, a broker) who owns it and to sell it to the market. Over the period, if the prediction is appropriate 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'll make a loss.
Besides taking a short-sell position, you may also consider taking a short position inside 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 specific stock or index is currently overvalued and may face a market correction soon, you are able to 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 actual asset. Rather, you are entering into a contract with the CFD provider to exchange the difference between the price of a good thing when the trade is open and the price of an asset when the trade is closed.
You can also increase your market exposure and therefore your potential profits or losses via leverage.
CFDs Supply 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're already vested in, or capitalise on stocks/indices which are potentially overvalued, CFD is an instrument you can look at using to meet specific objectives inside 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 2021). Opening a merchant account with IG is free and enables you to trade CFDs across various asset classes such as stocks, indices, forex as well as commodities.
When you open an account with IG, you gain access to the IG Academy, that provides online courses, live sessions and webinars that you simply take part in to improve your trading skills. Addititionally there is 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, providing you with the opportunity to get familiarise using the platform you are using and the strategies you need to deploy before you commit money into your CFD trades.