A trader’s guide to high-risk investments
High-risk investments have a greater chance of losing money, but they also sometimes have a greater potential for large profits. Here we explain what high-risk investments are and highlight a few popular high-risk investments.
What is a high-risk investment?
A high-risk investment is an opportunity to profit which, due to an asset’s inherent volatility, has an increased risk of losing money. Sometimes, high-risk investments have a greater potential profit when compared to more conventional investments, but this is paired with an equally increased risk of loss.
However, while some investments can be considered riskier than others, it is important to remember that all trading and investing involves risk. As a result, you should ensure that you are comfortable with your exposure, and that you understand the risks presented to you during your time on the markets.
What does ‘high-risk, high-return’ mean?
‘High-risk, high-return’ means that an opportunity has an increased degree of risk, but this comes with an increased potential return. High-risk, high-return is sometimes referred to as the risk-return trade-off, and it is a theory which states that the potential return of an investment is greater when there is an attached increased risk for that particular investment.
Understanding the risk-to-reward ratio
The risk-to-reward ratio is used by traders to compare the expected returns of a particular trade or investment against the amount of risk to which they will be exposed for the duration of that trade or investment.
As a result, the risk-to-reward ratio can be used by traders to determine the level of potential downside and their possible losses, while also suggesting the potential upside of a trade and their possible profits.
A risk-to-reward ratio of over 1.0 means the risk is greater than the expected return, and a ratio below 1.0 means that the expected profit is greater than the potential risk.
High-risk investments vs high-risk trades
Investing and trading are two different ways to get exposure to the financial markets. With investing, you are buying an asset such as a stock outright; with trading, you are using financial products such as CFDs to speculate on the price of the underlying asset without taking ownership of it.
If you’d prefer to trade on the price of an asset such as stocks, commodities or forex without having to own the underlying, you can do so by trading CFDs. These are financial derivatives which enable you to speculate on the price of an asset rising (known as going long) or falling (known as going short).
The degree to which your assessment of an asset’s price movement is correct determines your profit or loss. If you go short, you will need to price of an asset to drop for that trade to be profitable and if you go long, you will need to price to rise.
Risky trading opportunities
The following examples of risky trading opportunities have been identified as high-risk investments or trading opportunities due to the inherent volatility and uncertainty in their respective markets.
Trading lottery stocks
Lottery stocks are those of companies which are currently trading at a low value, but which could yield high returns if they are successful in salvaging their operations or in restructuring any debt.
An example could be Sirius Minerals, where the company’s success relies on an increased demand for the potash fertiliser it is trying to mine underneath the North York Moors. Rumours of bankruptcy and a series of setbacks, which caused share price to drop by roughly 85% from April to August 2019, have so far not played out well for the mining company.
If a company manages to resolve its problems, the stock price could well increase, meaning that traders who bought in when the stock was low value stand to receive large profits. Typically, lottery stocks are in the fintech, mining, pharmaceutical or biotech industries.
Bankrupt companies with public listings are also usually considered lottery stocks because they trade at very discounted prices but, if the company manages to recover from bankruptcy, they have the potential to generate large gains. However, these are risky investments because a company is usually bankrupt for a reason, whether that be lack of consumer interest, poor management or internal corruption.
Because of the high risk attached to trading lottery stocks, traders often seek out cheap or ‘undervalued’ stocks. When investing in lottery stocks, the maximum you can lose is capped at the value of your position; when trading lottery stocks, your losses can exceed your initial outlay, but there is a range of risk-management tools that can be used to reduce your potential loss.
Trading initial public offerings (IPOs) can be particularly risky due to the lack of financial information before the company goes public. However, a company will issue a prospectus before an IPO, so traders can look at the company’s leadership, as well as the underwriters for the IPO.
Often, if an IPO is underwritten by a large bank or other financial institution, it stands a good chance of success and the company’s share price could well increase once the company publicly lists. Underwriting means that a bank or financial institution has pledged to buy all of the unsold shares after the new shares are issued.
If more market participants think that the company will list with a large market capitalisation, it could be a positive indicator that the IPO will be a success and that the company might be work investing in or trading on.
Trading volatile currency pairs
Forex as a market is already the most volatile in the world, with $5 trillion worth of forex transactions taking place every day – however some currency pairs are more volatile than others. Volatility can be good for traders, because it means that price movements are more frequent which offers more scope to realise a profit – either by going long or short.
However, while it increases the opportunity to profit, volatility does not necessarily increase profits outright, but it does increase that market’s inherent risk. Some things to bear in mind when trading volatile currency pairs is that they can have lower levels of liquidity than their less-volatile counterparts.
This can be problematic if a trader wishes to exit a trade quickly, as lower liquidity means that there are fewer market participants to take the other side of a trade. However, with an effective risk management strategy in place, volatile currency pairs should not be something to fear.
Guaranteed stops are one popular way traders minimise their exposure to risk on the forex market. A guaranteed stop will always close your position if the price falls to a specified level, but you will need to pay a premium if it is triggered. This means that you are at less risk of slippage, and your losses are predefined and guaranteed at a level which you have determined you are comfortable with.
Typically, currency pairs are volatile because of political events – such as Brexit – or other factors such as interest rate differentials, the economic strength of each currency’s issuing country and the value of these countries’ exports and imports.
Trading emerging markets
Trading emerging markets is an exciting prospect for traders who want to capitalise on the perceived growth that emerging markets will experience in the coming years. Typically, an emerging market refers to a country which shares some characteristics of a developed market, but which does not unequivocally satisfy the standard by which markets are deemed to be developed.
Usually emerging markets might have more relaxed trading regulations, they might have high levels of corruption or they might be politically unstable. The Group of Five – made up of Brazil, China, India, Mexico and South Africa – is a good example of a collection of emerging markets, but that is not to say that these countries are particularly corrupt or politically unstable.
Trading emerging markets carries a unique set of risks as opposed to other forms of trading. Foreign exchange risk, less stringent regulations, lack of liquidity and political uncertainty are all things to consider before taking a position on emerging markets.
Trading penny stocks
Penny stocks are typically defined as any shares which trade at 100p or below. Individuals who invest in or trade on penny stocks often do so with the hope of identifying a company with a considerable potential for profit in the future.
Usually, these companies are few and far between, with the main risks of penny stocks being a lack of liquidity, and that the companies often lack transparency or make false claims about future success. This is because penny stocks often don’t meet the requirements to be listed on the major stock exchanges, and they are instead traded over-the-counter. This means they are subject to fewer regulations than other stocks which trade for a higher price.
As a result, penny stocks can sometimes be a target for price manipulation, where dishonest traders or brokerage firms might inaccurately promote the shares of a company in order to push the price of the stock up.
Other traders who are looking to profit might buy into this advice, which will cause the stock’s price to continue to rise. All the while, those who promoted the stock could choose to sell their stakes, which will usually cause the price of that stock to crash during a large sell-off.
Technical indicators like the stochastic oscillator might be useful when trading penny stocks, as it can help to identify stocks which are overbought or oversold. The stochastic oscillator is a range-based indicator, meaning that it is always relative to values between 0 and 100; values above 80 are considered overbought, and values under 20 are considered oversold.
Trading cryptocurrencies is still a popular strategy for many market participants. This is although many consider the crypto boom to be over, but that does not mean that opportunities to profit have disappeared. There is still a lot of volatility in the cryptocurrency market, which means that the risks are there, but so is the opportunity to profit from either going long or short.
One of the main risks with trading cryptocurrencies is that they are not regulated by central banks or by governments, and so they can be susceptible to hacks and scams. A large-scale hack occurred in January 2019 on the Japanese coin exchange Coincheck, where $534 million worth of NEM coins was stolen.
Other hacks have occurred throughout the history of cryptocurrencies, meaning that they are susceptible to a unique risk that currencies, stocks or IPOs are not. A benefit to trading cryptos – as opposed to investing – is that you are not at risk of losing your coins in a hack, because you never take ownership of the underlying asset.
Pros and cons of high-risk investments
The pros and cons of high-risk investments must be assessed on a trade-by-trade basis. However, high-risk, high-reward trades sometimes enable a trader to realise a greater profit than if they had been more risk-averse.
This is not to say that high risk will guarantee high return, and an inherent downside of a high-risk investment or trade is that you could stand to lose a significant amount of capital if your predictions are incorrect or if sinister forces are at work in the markets.
Before taking a high-risk position, you should have a risk management strategy in place to determine when you should enter and exit, including what your stop and limit levels are. Stops such as guaranteed stops and trailing stops can help to mitigate your losses; limits enable you to lock in profits once they have been achieved.
This information has been prepared by IG, a trading name of IG Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.
CFDs are a leveraged products. CFD trading may not be suitable for everyone and can result in losses that exceed your initial deposit, so please ensure that you fully understand the risks involved.
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