Risk-off vs. Risk-on Trading
A risk-off/risk-on environment is defined based on how the market, in general, is seeing a specific event. To be more exact, it is representing the market reaction to a specific event and this reaction might take a day, a week, or even more. Trading the currency markets is all about perceptions, especially these days when humans are following robots. Therefore, how an event is being perceived plays an important role. Sometimes the market is so strongly biased that economic releases won’t even matter in the general trend, and the countertrend move is used only for adding to the initial position. Strong trends tend to have a correlated nature among the Forex currencies, and this is what risk-off/risk-on means.
Defining a Risk-Off/Risk-On Environment
Any Forex broker is offering multiple currency pairs to be traded, and these pairs are being divided into two main categories: majors and crosses. A major pair is one that has the USD (U.S. Dollar) while a cross is any another currency pair that doesn’t have the dollar in it. The reason why the currency pairs are divided like this comes from the fact that the US dollar is the world’s reserve currency. This means that the monetary policy moves that the Federal Reserve of the United States is making makes the market shifting aggressively. Because of the U.S. dollar’s role, the currency pairs are moving in a correlated manner. If the dollar is bullish, dollar pairs will all move in the same direction, with the same being valid if the dollar is bearish. However, this is not what a risk-off/risk-on move is. Besides the currency market, equities and commodities are being involved as well.
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How to Trade a Risk-Off Environment?
A risk-off environment is defined when market sentiment is a negative one. Under such an environment, investors/traders seek safe in currencies associated as being safer. The CHF (Swiss Franc) and the JPY (Japanese Yen) are currencies that are being bought under a risk-off sentiment, as they are being viewed as safe-heaven. Therefore, the USDCHF is moving to the downside and the USDJPY as well. A risk-off sentiment is dragging the U.S. equities indexes to the downside as well, and these, in turn, will drag the global stock market to the downside. It is no secret now that globalization makes financial products move in a correlated matter. The USDCAD is typically a currency pair that is moving to the upside under such conditions, but this currency pair is influenced by the oil market. This makes it a bit more difficult to predict its moves and it is not always associated with a risk-off sentiment. The classical example and the most recent one happened when the U.S. presidential election took place at the start of November 2017. The election of Mr. Trump as the President of the United States has been perceived by markets as being a risk, rather than the election of Mrs. Clinton. This made the risk-off moves as described above, happening all the time a positive news regarding Trump was released. Therefore, this environment was holding for the whole presidential race, and even into the election night. However, at the time it was obvious that Trump is going to win the election, the market turned and, instead of a risk-off sentiment, a new one, a risk-on started.
How to Trade a Risk-On Environment?
A risk-on sentiment is exactly the opposite of a risk-off and it means the market is in a bullish mode. That is, the equity market! From a currency pair point of view, some currencies are moving up, others down, but the overall idea is that the U.S. dollar is being bought against the currencies that are being perceived as representing the risk. Typically, a risk-on environment is defined as a correlated move that sees the USDCHF, USDJPY, equity indexes, moving to the upside. On the other hand, the USDCAD is moving to the downside as the oil price is most likely to rise. It is worth mentioning here that both risk-on/off moves were different some time ago. They were defined by the EURUSD, GBPUSD, AUDUSD, NZDUSD, moving up, while USDCAD moved to the downside, in a risk-on sentiment. In general, the U.S. dollar was sold aggressively under such a move. This changed lately because central banks moved rates into negative territory and are engaged in unconventional monetary policy moves. The Quantitative Easing programs that ran/still run all around the world distorted the risk-on/off sentiment as it was known before. Under such programs, the central banks are buying their own government’s bonds, with the idea being to create inflation. Markets had to adapt to this new reality and these days we’re seeing negative interest rates in many important central bank’s jurisdictions around the world. Such negative rates environment has the purpose of stimulating commercial banks to lend more money to the real economy, thus creating jobs and economic growth will pick up. Together with economic growth, inflation will pick up us well, and by the time that this is happening, central banks will normalize the monetary policy. Until then, however, markets adapted to the new realities and the risk-on/off sentiment has been defined. As a rule of thumb, a risk-off trade is being perceived as one that is selling the riskier currencies against everything else on the dashboard. These currencies are the CHF and the JPY. A risk-off situation is a bearish one, or a negative one, and the panic sentiment takes over markets. Typically, in a panic situation, prices are moving faster than in a bullish case, so traders need to react very quick to it. Ahead of an event being perceived as a risky one, typically Forex brokers are sending emails announcing their clients that the margin requirements are increasing. Wider spreads are to be expected as well, and stop loss and take profit orders usually are being executed with slippage. Under a risk-on move, the sentiment is bullish and currency pairs are moving at a normal pace. After all, a bullish environment is always considered to be a positive one. Knowing what to expect from a risk-on/off perspective gives traders a competitive advantage. This is very helpful when trying to avoid overtrading, as trading correlations should help to do that.
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Recommended further readings
- New evidence on the determinants of bank risk. Stiroh, K.J., 2006. Journal of Financial Services Research, 30(3), pp.237-263.
- “Risk-on/risk-off, capital flows, leverage and safe assets.” McCauley, Robert N. (2012).