Top 3 Low-Risk Trading Strategies

Key Points

• While no investment is risk-free, some strategies are less volatile than others.
• Lower-risk techniques often cap an investor’s maximum upside while limiting losses.
• Low-risk trading can be profitable, but it’s not a substitute for due diligence, and investors must set proper expectations.

One of the tell-tale signs of a scammer is any promise of a risk-free investment. No one offering significant returns with zero risk has good intentions, and you’re more likely to see the Cleveland Browns win the Super Bowl before a legitimate "risk-free" investment opportunity. Sure, you can earn around 4% by sticking cash in an FDIC-insured savings account right now, but even that insurance comes with a $250,000 limit.

The reality is that investing always comes with risk. But that doesn’t mean all risk is the same. Some types of risk are inherent to markets, while others are unique to a specific asset class, stock sector, or individual company. Additionally, some trading strategies are higher risk, like buying out-of-the-money options or penny stocks, while others contain less risk, such as diversification, trading liquid exchange-traded funds (ETFs), or using derivatives to limit downside exposure. In this article, we are going to be looking at three low-risk investment strategies that can help you achieve safe and steady returns. And while low-risk strategies can still lose money, they’re good places to start for investors looking to start active trading.

1. Pairs Trading

Pairs trading involves two securities with a historical relationship and looking for imbalances in their traditional equilibrium. A pairs trader often buys one security while selling another, hoping to profit when both assets return to their normal range.

Here’s an example: let’s say McDonald's Corp (NYSE: MCD) has a sudden stock surge with no catalyst, and no other casual dining company rallies along with it. In this scenario, a pairs trade might have success. You could sell MCD shares short while buying shares of Wendy’s Company (NYSE: WEN), anticipating a pullback in MCD while also protecting yourself should the rally continue and WEN shares join the momentum.

Pros of Pairs Trading

Pairs trading offers several advantages, making it a versatile and risk-managed strategy for investors seeking opportunities in different market conditions.

• Works in Many Environments: Pairs trading works in all kinds of market scenarios since the assets involved don’t need to be in a particular sector or industry, they just need to have a correlation that an investor can track.
• Limits Losses: Pairs trading is designed to profit from temporary mispricings, allowing the investor to cash in as the trend reverts to normal. In theory, losses on one asset should be offset by gains in the other, which limits the total amount of capital you can lose on the trade.
• Remains Market Neutral: You don’t need to be bearish or bullish to engage in pairs trading. Just because you’re trading fast food companies doesn’t mean you think the sector is due for an uptrend or pullback. By buying one asset and selling another, you remain "market neutral" and relatively ambivalent to the companies themselves.

Cons of Pairs Trading

Despite its advantages, pairs trading comes with certain drawbacks that can affect profitability and require careful consideration by investors.

• Requires Complicated Planning: Since you’re trading a pair of securities, you’re performing double-duty due diligence. This means you’ll need to review two balance sheets, listen to two investor conference calls, or analyze two different charts when attempting a pairs trade.
• Involves Transaction Costs: If you’re trading securities that carry commissions like options and futures contracts frequently do, these added costs can take a serious bite out of your profits. Even commission-free stocks and ETFs come with bid/ask spreads, so avoid overtrading when using a pairs strategy.
• Limits Potential Profits: Another cost of taking the middle ground is the upside cap on profits. Yes, losses are limited by trading a pair of assets, but you also won’t reap the full benefits should one of the securities break out beyond your expectations. For example, if Costco Wholesale Corp. (NASDAQ: COST) jumps 20%, you won’t see a 20% gain in your trade since you shorted BJ’s Wholesale Club Holdings (NYSE: BJ), which is now rallying in sympathy with COST.

Stop-Loss and Take-Profit Orders

Using different order types can also help mitigate risk. You’re probably familiar with market and limit orders, but other advanced order types can set automated gain and loss limits. If you use a stop-loss order, you’ll automatically exit a position should the asset price drop to your predetermined level. Take-profit orders work in the opposite direction; your exit trade will automatically execute when a specific profit goal is reached.

Pros of Stop-Loss and Take-Profit Orders

Stop-loss and take-profit orders offer several benefits that can help traders manage their positions effectively and reduce stress.

• Puts Trading on Autopilot: Once you’ve set a loss limit or profit goal, you can submit the order and let the market do the work. A stop-loss order will turn into a market order and execute, but only if the asset declines to your predetermined loss limit. Otherwise, it will simply expire or remain in limbo until you alter it.
• Removes Emotions from Trading: By setting take-profit or stop-loss orders, you’re predetermining your exit from the trade based on a set of ground rules. That’s a good thing! Sticking to your plan and reducing emotional decision-making is easier said than done. Using advanced order types keeps your itchy trigger finger at bay and exits the trade based on clear-headed thinking.

Cons of Stop-Loss and Take-Profit Orders

Traders should pay attention to the following considerations when making stop-loss and take-profit orders.

• Leaves Potential Profits on the Table: When you set a take-profit order, it's often wise not to look at the stock for a bit after the order is executed. Every now and then, you’ll see that taking profits at 20% caused you to miss out on an additional 50% as the stock continued skyrocketing. Don’t fall into FOMO with advanced order types! Stick to your rules, but understand that low risk sometimes means hitting singles instead of home runs.
• Suseptible to Slippage in Volatile Markets: When stocks are moving rapidly and unpredictably, your take-profit or stop-loss order may not be executed precisely. This is known as slippage, which happens when prices move faster than your broker’s software can keep up. When your stop-loss price hits, it turns your order into a market sell order, which only guarantees the best available price. Stop-loss and take-profit orders aren’t foolproof and occasionally fail to match your desired price during volatile periods.

Covered Call Writing

Covered call writing may seem like an advanced strategy since it involves options, but it's actually a conservative technique designed for upfront income and protection against large losses. Here’s an example: if you owned 100 shares of Apple Inc. (NASDAQ: AAPL), you would then write (or sell) a call option with a strike price above the current market price. 

As the option writer, you collect the premium from the buyer and protect yourself by owning 100 shares of the underlying stocks. If AAPL stays flat or drops, the option will expire worthless, and you keep the premium as profit. If the stock reaches the strike price and the buyer exercises the option, you deliver the 100 AAPL shares you already owned and close out the position.

Pros of Covered Call Writing

Writing covered calls can be a strategic way to generate income and manage risk, especially when you anticipate the underlying stock to remain stable or decline slightly.

• Generates Income Through Premiums: A covered call strategy is executed when you predict the underlying stock will decline or remain flat. The premium you collect upfront is your profit, and it ideally offsets any potential losses from the underlying stock. Receiving your profit first is beneficial as it can be directed toward other trades or assets.
• Limits Downside: The maximum amount you can lose using a covered call strategy is the difference between your initial stock purchase price and the option strike price minus the premium you collected for selling the option.
• Hedges without Shorting: Using covered calls, you can hedge an open stock position without margin or short-selling. Borrowing money always enhances the risk of a trade, but a well-designed covered call protects you from a drawdown without margin.

Cons of Covered Call Writing

Covered call writing does come with certain risks and limitations.

• Limits Upside Potential: The nightmare scenario for any covered call writer is a parabolic increase in the underlying stock. If you write a call option and your underlying position doubles, you won’t reap those benefits, as you’ll need to deliver shares to the option owner at the strike price. You’ll keep the premium but miss out on the massive gain.
• Involves Assignment Risk: When trading options, the buyer can exercise the option as soon as the strike price is reached, not when the option expires. If the option buyer exercises early, you may need to deliver your shares before you originally anticipated.
• Requires Extra Legwork: Covered calls are low risk only when properly calculated and executed. Derivatives like options carry certain complexities that investors must understand, especially when writing calls. If you don’t select the right strike price or expiration, you might wind up with bigger losses than you can handle. 

Some Trading Techniques Are Less Risky Than Others

If you’re looking for a risk-free investment, you might be looking for a while. No investment is completely free from risk, and anyone claiming otherwise is likely attempting to sell a scam. While you can’t eliminate risk, you can reduce it a bit by utilizing strategies like pairs trading, stop-loss orders, or covered call writing. Check with your financial advisor first to ensure these strategies fit your investment plans.

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