by Jeff Reeves | November 1, 2012 6:15 am
Maybe you’ve heard the phrase “risk on, risk off” to describe the stock market’s ups and downs. The theory goes that when investors are feeling good and confident about things, they start to dip into riskier assets such as small technology and healthcare companies in the beginning phases of what could be a big idea. When investors are feeling nervous, they bail out of stocks and hunker down in defensive options like highly rated corporate bonds.
We can quibble over whether right now is “risk on” or “risk off.” On the plus side, the markets are up strongly year-to-date; on the negative side, earnings are as bad as some pundits feared going into this current round of quarterly reports. There are a lot of arguments right now as to which side of the risk equation you should be on.
However, it’s important to note that there are some super-risky plays that some investors are dabbling in to generate big gains in any market. These sometimes can wind up being big money losers and admittedly take a bit more sophistication and practice to figure out — but if you’re willing to play, you could unlock outsized returns that a conventional long-term investment portfolio can’t match.
If you want to take the tiger by the tail, here are five risky games that investors are playing, as well as how to get started if you want to play, too:
Short sales are intriguing to many investors because they allow you to play the downside of a company by reversing the order of the transaction so that you sell first, then buy later. Since all transactions must be resolved eventually, your portfolio will be “short” a given equity until you buy back to “cover” — hopefully at a lower price, creating a profit.
This is a deceptively simple form of trading, but the risks are significant.
For starters, short sales can only be made from a margin account that requires you to have a certain amount of cash in reserve to cover any trades. After all, it’s silly to think a broker would let you just “sell” as many stocks as you want and never worry about whether you could afford to eventually buy them back. As long as you make good trades you’ll be fine … but if you ever find yourself on the wrong side of a short sale, you might be faced with the dreaded “margin call,” where a broker insists that you either close the trade or front more money to prove you aren’t in over your head.
These events typically come at the worst time, since you are already in a bad spot on a poor investment and now the broker is knocking for cash you may not have. Do you sell just to get out, or do you scrape together the cash and hope for a rebound? It’s a stressful situation.
Another troublesome feature of short selling is that since you sell first, you have theoretically unlimited losses. For instance, if you buy a stock at $10, the worst it can do is go to zero and give you a 100% loss. But if you sell at $10, it could go to $20 and lose you 100% … or it could go to $21. Or $31. Or $131! Imagine covering a trade at $131 when you sold short at $10 — for a 1,300% loss. It’s rare, but it happens.
Still, if you have the discipline and research to short stocks effectively, it can be a powerful tool for profits. Most major brokers offer a way to sell short, but read the fine print on fees and margins because pricing will differ and could result in charges above and beyond a plain ol’ equities account.
Ever heard of the phrase “buy the rumor, sell the news?” This is the practice of getting in quickly before an event moves the market or a specific stock, then getting out immediately afterward. Although individual moves in and of themselves might not be substantial at just a few percentage points here and there each market session, collectively they can add up.
Imagine you have $10,000 to invest and you focus on simply getting 1% a day, each day, for the entire year. Nominally it’s a measly $100 in returns per session … but with about 240 trading days, that’s $24,000 in profits by year’s end! Heck, if all you average is 0.4% a trading day, you nearly double your money in 12 months.
The barrier to this, of course, is being tied to your computer to make those swift in-and-out trades and having the IQ to digest what’s going on and connect it to trades. It could involve buying a stock right before highly hyped earnings, or buying immediately after a bad headline hits to take advantage of the “dead-cat bounce” after shares sell off sharply. It could involve making directional bets on sectors or even the broader market based on macro news.
And even presuming you have the time and the brainpower, there’s always the problem of trading fees and short-term capital gains if you’re trading in a taxable account. Those short-term bets come at a much higher tax rate, and if you only make $100 a day, there’s a real chance that profit will be eroded substantially by a $5 to $10 trading fee for every transaction you make.
But if you have the time, a tax-free IRA or the means to make the trading fees and taxes worth it, day trading can unlock big-time opportunities that buy-and-hold investors simply can’t capitalize on. Best of all, you often don’t have to open a different account to make these trades — simply use your existing platform, just use it more often.
Currency trading (aka forex) has become highly lucrative and increasingly popular in this age of global volatility and sovereign debt messing with exchange rates. But many of us are intimidated by the concept, seeing as our only experience with currency fluctuations is limited to foreign vacations and how they impact our credit card bills.
To get started with forex, you first have to understand the complex nature of global currencies and how they are very much a measure of confidence in the underlying governments and economies they support, not just directionally relative to their past but also versus peers elsewhere in the world.
For instance, the strength of the U.S. dollar might not seem like a sure thing to you as our federal deficit soars and unemployment remains high at home … but considering the alternatives in the world are the debt-addled eurozone or struggling emerging markets, things are looking pretty darn good for the greenback. Currency trading has as much to do with geopolitics and investor sentiment as it does with macroeconomic data points.
Even if you can accurately gauge what way currencies will move based on your analysis, the bottom line is that forex is a game of tiny increments — fractions of a cent, taken in large quantities to create profits. That means a constant connection to the market to take advantage of these small moves (akin to day trading) and the use of leverage and margin to maximize your investment profits. It also means paying close attention to your spreads to ensure you pay the lowest amount possible for your transactions. Every penny and fraction of a penny counts!
That brings up the biggest risk of all: Because forex involves such tiny moves and the need for big bets to make any money, it’s easy to get over your head. If an investment seems great but you have to plow a huge amount of cash into it to make the math work … well, that’s good if things go as planned. If not, you can be left with a very costly mistake.
Forex brokers vary in their services and scope, so shop around. Unlike equities, forex transactions don’t involve a commission, but rather a small fee based on the difference in spreads between what you can buy or sell a currency at. The bottom line is that lower spreads means lower cost, so browse like you would for commissions on a brokerage account. Also pay attention to margin rules and flexibility in leverage. As with short-selling, a dreaded margin call is possible if you don’t read the fine print or prepare accordingly.
Commodity futures trading involves buying and selling contracts for the future delivery of physical raw materials. This includes metals like copper, grains like soybeans, energy goods like crude oil and even livestock. It’s important to note that you aren’t investing in the goods in a vacuum here, but the future delivery of those goods.
That’s why they’re called “futures” — because you’re trading the time element more than anything else.
For instance, futures are commonly used by farmers to ensure pricing down the road for their crops and thus mitigate risk. For the sake of argument, let’s say a farmer pays $1 for a contract that gives him the right (but not the obligation) to sell a bushel of corn for $10 next fall. If the price of corn drops significantly, he exercises his contract and protects against losses. But if corn skyrockets to above $10, then he allows the contract to expire unused and his $1 fee was merely the price of his peace of mind.
Where do you come in, then, if you are neither buying or selling corn? Well, you are the middleman on the futures contracts themselves.
Let’s say you buy that very same $1 contract to sell corn at $10 … but rather than worry about selling corn, you worry about selling that futures contract to someone who wants it. If corn drops to $5 a bushel, you can be darn sure farmers and other investors are going to be falling all over themselves to buy that contract from you for much more than $1.
The flip side, of course, is that corn goes to $20 and nobody on God’s green earth is at all interested in selling their corn for $10, so your $1 “investment” in that futures contract winds up being a 100% loss without any buyers to take it off your hands.
If you’re an options trader who is familiar with this concept of trading contracts more than the underlying securities or commodities, futures might be a decent fit. But be warned that run-of-the-mill brokerage accounts don’t offer commodity futures and that the amount of research and analysis on individual commodities is much more arcane — including weather patterns, mining output, supply chains and other issues.
Perhaps the most satisfying investment of all is one where you set out to invest in yourself or an enterprise that you personally have a hand in.
Of course, this is frequently a very risky venture because, unlike a blue-chip stock or a collectible coin, the value of this investment is based wholly on your expertise and work ethic instead of sentiment and capital markets.
If you have a knack for writing, just a few hundred bucks can get you a domain name and server space for a website, and a few hundred more can design a killer blog. If you have a knack for home improvement, buy some tools and a truck and take out a few ads in the local newspaper. If you want to go back to school for your MBA, take out some student loans and cut back on your “day job” to focus on your education.
The downside of this equation, of course, is that some self-starters fall flat on their face — and aside from the lost money, there’s the emotional burden of failure should things go awry. Similarly, most “profitable” investments in yourself are predicated on the fact that your time isn’t worth much. If you make enough money from your home improvement business to pay for your tools, that’s great … but consider if you never took on a single job, you could have worked anywhere for minimum wage and done better than break even.
Those folks with a busy schedule might find the idea downright impossible, and the risks of starting their own business too much to bear. But aside from the satisfaction of being your own boss — even on a part-time or occasional basis — you might find this is the most profitable long-term investment you’ve ever made should things go well.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP.
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