Except for quick action scalpers, most short term players still have to identify risk on / risk off scenarios.
What is risk on / risk off?
Simply – risk on is when traders and investors become optimistic and are willing to bear more risks, running up equities and other high yielding trades. Risk off pertains to heightened levels of conservatism, “flight” to safer assets such as treasuries and general sell offs of risky currencies and equities.
A risk off situation often strikes unsuspectingly, eg. an unilateral declaration of war by the US, but may also be widely anticipated eg. the US debt ceiling impasse that will be served this end September.
How do we know if a risk off situation has dawned upon us? How may this affect the Forex trade?
Price action traders often chirp that prices reflect market sentiments. I tend to agree, but must confess, many times I am still confused by the pricing gymnastics that play out on my screen. Often enough, “experts” also disagree on the severity and impact of a potential risk event. To maintain sanity, I bear note of the following:
- Some situations are difficult to categorise as risky or not risky. But regardless of how we grade them, the market must be the final arbiter of whether a risk off affair has evolved.
- The Swiss Francs and the Yen are often the first currencies to react (appreciate) in a risk off scenario. Together with the USD, these three tend to appreciate as safe haven currencies. However one has to mind country specific factors that may temper any appreciation. As I write this now, the US debt ceiling debacle is threatening to invoke a risk off process. The USD has dropped most of yesterday (since US is the culprit behind this risky affair) – but the Japanese Yen also plummeted about an hour ago – on talks that its largest pension is reshuffling its portfolio and possible corporate tax cuts. Who knows what will happen to the CHF?
- Emerging currencies and mainstream currencies like Euro, GBP, AUD and NZD tend to depreciate in risk off scenarios. The latter 4 tend to be first responders and react more quickly than the Canadian dollar or Singdollar.
- The VIX (options on the S&P 500) is also often used to gauge risk tolerance in the market.
- The AUD/JPY pair also tends to fall in a risk off situation and is a key barometer for risk tolerance in the market. (Unless of course, the Japanese surprise us with “stimulus” measures.)
- Higher yielding currencies tend to be more affected when crossing from risk on and to off situations.
- A country which has a strong balance sheet is less likely impacted in a risk off situation. However, if there were huge equity and debt inflows into the economy prior to the risk off dilemma, hedging activities in risk off situations may weaken the economy’s currency.
- When equities related markets decline and treasuries run up, they can be indicative of a risk off situation.
- The price of precious metals such as gold and silver, if they push up from a stable base, may also indicate disconcerting uncertainties.
Some fellow traders also look to option prices and bond yields to augment their understanding and develop hedging strategies in a risk off scenarios. Good for them, but simply too much of an overload for me.
Since 2007, the forex market had been plagued with more risk off situations. The financial crisis had left a legacy of volatile time bombs waiting to trip us or provide unconscionable profits. It is thus important for a forex trader to be discerning with risk on and off sentiments, to take advantage of long and short opportunities as well as mitigate costly risks.
(Update 28 Sep 2013)
A friend asked me why the Euro ran up in the potential risk off scenario (US Debt Ceiling Impasse).
Generally in a risk off situation – the USD will run up as a safe haven currency, and this has a tendency to drive the Euro down (ie. Euro/USD pair drops). But since the US is the source of risk off worries this time, the US dollar was sold off heavily as investors hedged or speculated. The US dollar index is weighed approx. 50% against the Euro. As the weight of the USD plummet was heavier across the board against major currencies, it naturally pushed the Euro up. Sounds reasonable? I wish life is as easy. Can it be too, that as the Euro was rising, the market makers were happily selling to the Euro longs. If this be true, we shall be waiting for a larger Euro sell-off subsequently.
Nevertheless, an important signal of the risk off situation was the key support breaking plunge in the USD / CHF pair – ie. the USD was sold down, while the Swiss Francs was heavily bought into. Generally the USD/CHF pair and Euro/USD have an inverse relationship.) The flare up in the VIX was also indicative of a possible risk off situation developing.
I have not reached that level which can distill the true reasons behind the moves. If I finally do, it will be great. If I do not, it is still alright. Did I scalp long the Euro on Friday 27 Sep – no. Did I scalp short the USD/CHF pair on Friday – yes. (The rationale was the pair’s price action and related sentiments were agreeable with each other.) In hindsight, it would have been great to do a longer duration trade on the USD/CHF pair. But given the uncertain developments over the coming weekend,and the potential weekly wrap up of the Euro and USD trades on Fridays, it was not going to be an easy trade. I was happier with the scalp return and a new movie screening (“Young Detective Dee”). After all, profits can always be made on easier days.