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Which one of the following financial instruments is a derivative product:
Explanation
CFDs are derivative instruments while individual shares, commodities and bonds are assets that you can trade using derivatives.
The biggest holding in your long-term share dealing portfolio releases disastrous year-end fiscal results. The company’s share price drops 10% overnight. Had you shorted the same share using a CFD before this happened, you would’ve:
Explanation
The value of your shares would drop by 10%, but because you took a short position anticipating that the market would fall, you would’ve made a profit from its movement.
You own a few shares in a popular UK oil company. You read about an upcoming environmental policy in the UK that will introduce heavier pollution penalties for oil companies. To ensure that your overall portfolio stays in the black, you:
Explanation
You’d place a ‘sell’ trade or go short on the oil company you
hold shares in, since news like this is likely to cause the oil company to drop value.
Selling your existing shares may seem like a good decision to avoid major losses, but it requires careful consideration because some companies are more resilient than others and may bounce back quickly.
You hold shares in an international transport company. You’ve also opened a long CFD position in Brent Crude Oil. If the price of oil suddenly shoots up, what could happen to your combined investment and trading portfolio?
Explanation
You’d expect an increase in the oil price to increase the transport company’s costs, likely resulting in the company losing money and making lower profits. This could cause investors like you to sell their shares in the company to avoid losses, which would then result in a lower share price.
However, your long CFD position would appreciate in value because ‘going long’ on a trade means you expect the price of the underlying asset to increase. Because your long position was on the oil price rising, you would’ve been able to close your trade with a profit made.
You told shares in Vodafone, which is priced in British pounds (GBP). You think that the value of your base currency, the US dollar (USD), will appreciate against the GBP soon. This could result in some losses if you sold your Vodafone shares after this happened and converted them back to your base currency. You also don't want to sell your stake at the moment because your analysis found that Vodafone may experience major gains in the coming weeks before a selloff is likely to occur. So, you hold your stock. In this situation, which of these CFD positions would you open to manage your currency risk?
Explanation
A drop in the value of the USD would mean your shares are worth less in GBP than when you bought them. To cover this loss, you can take a long position on GBP/USD to profit from the GBP’s rise in value.
If you held shares in a local sugar mill company and the price of sugar dropped in your country, which of these CFD trades would you likely want to make?
Explanation
If the price of sugar suddenly dropped, the value of your shares would fall. However, you’d still be able to capitalise on the change if you held a short CFD position on both the company and the commodity.
One share in ABC plc costs $200 and you’re confident that it will appreciate by $50. However, buying ten shares would cost you $2000, so you decide to trade the shares using CFDs instead. Your derivatives trading provider only requires 20% of the stock’s value as the initial outlay for you to buy one CFD. So, you buy ten standard contracts to open a long position. If the stock does appreciate by $50, you would’ve:
Explanation
You would’ve put down only $400 of the $2000 needed to buy the shares outright. In the end, your long position would’ve earned you the same $500 profit you could’ve made by buying shares but at a fraction of the cost. However, if the trade went against you, you’d also stand to lose more.
You own 200 shares in XYZ plc, worth $20,000 in total. You open a short position of 15 standard CFDs. One share costs $100 and you put down a 20% margin to open your position. If the company’s share price increased by $25 by the time you closed your CFD position, what would happen to your combined investment and trading portfolio?
Explanation
Your 200 shares would now be worth $25 each. So, that’s: $25 x 200 = $25,000
You would’ve lost $375 – and not just $187.50 – on your short
CFD position. This is because you had full exposure to the market, even though you only paid a fraction of the full trade value. So, your loss would’ve been on the full value of the trade and not just on the 20% margin.
You think Company B’s stock is going to drastically depreciate in the coming weeks. You own shares in the company and this loss will greatly impact your investment portfolio. Which of the following actions are you likely to take to protect yourself?
Explanation
A and B are both appropriate responses. However, if you’re anticipating a future decrease in value, then opening a long position would mean you lose money should that happen. A short position is the more logical choice as you’d make a profit from any potential downturn.
Which of the following statements about leveraged derivative products is true?
Explanation
Both A and B are true. However, it generally takes a short time to make a profit or loss when trading derivatives due to market volatility. So, C is not true.
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