How to understand Risk ’OFF’ or Risk ’ON’ Sentiment
The market sentiment looks to tumble back and forth on a daily basis among a ‘Risk On’ and a ‘Risk Off’ trading. Analyzing Risk Sentiment is as simple as following the movement of the US Stock Market.
Every day, it seems a new rumor is created and the stock markets moves consequently. The seesaw action can receive a toll on a trader’s emotions.
One of the best ways to determine an underlying trend in the market is through the risk appetite of traders. The advantage of understanding the condition of the market is it allows you to arrange your trades in the direction of the market sentiment.
DEFINITION OF ‘RISK-ON RISK-OFF’
An investment setting wherein price actions responds to, and is determined by, changes in investor risk taking. Risk-on risk-off refers to changes in investment activity in reaction to global economic patterns. During periods when risk is supposed as low, risk-on risk-off theory confirms that investors are likely to engage in higher-risk investments. When risk is supposed as high, investors have the aptitude to fall toward lower-risk investments.
Explaining ‘risk-On Risk-Off’
When you notice the stock market enhance significantly, that is a sign that risk is ‘on’. A risk ‘on’ setting is a mood of the market where traders feel good about the potential scenario of the economy. Hence, they take their capital and speculate in the stock market and high yielding instruments. This normally enhances the value of the stock market and high yielding currencies which now are the New Zealand Dollars (NZD) and Australian Dollars (AUD).
Simultaneously, low yielding instruments are likely to gain less on a comparative basis or possibly even lose value. Low yielding currencies are likely to be sold to fund the buying of a higher yielding currency. This selling of a low yielding currency while concurrently buying a high yielding currency is called the ‘Carry Trade’. So an outcome of a risk ‘on’ sentiment is a boost in the stock market and demand for high yielding currencies. Thus the Carry Trade strategy is likely to perform well.
In the chart above, as the AUD has historically been a very high yielding currency, while the risk sentiment was ‘ON’ (Green shaded areas) the AUD/USD exchange rate was about to RISE and the carry trade strategy worked very well. As soon as the risk sentiment turned ‘OFF’ (pink shaded areas) the AUD/USD exchange rate likely to FALL and the carry trade strategy did not performed inconsistently.
When you observe the stock market collapse like we did earlier this week that is signified as risk ‘off’ in the media. Which means traders and investors are not willing to take risk…they want to avoid risk and risky instruments. Hence, the investors pull their money out of market by selling their shares and selling their risky instruments like high yielding currencies. In a risk ‘off’ market condition, the carry trade does not work. Even if a trader is gaining a daily bonus, the movement of the exchange rates is so unfavorable that is eliminates any interest gains.