What does “risk-on, risk-off” mean for traders and investors?

Risk-on” and “risk-off” have become established terms in U.S. media coverage over the past few years as descriptions for certain market conditions and are also being used more and more frequently by German-speaking stock exchange traders. In this article I would like to explain in more detail what “risk-on, risk off” (RORO) means and how traders and investors can use the corresponding market developments.

Risk-on/risk-off describes how the markets react to events and are guided by changes in investors’ risk tolerance. RORO refers to changes in investment activity in response to global economic patterns. In periods when the risk in the markets is considered low, the risk-on/risk-off theory assumes that investors tend to invest in riskier asset classes. However, if the risk is perceived to be high, then investors tend to base their investment behavior on low-risk investments.

Risk on, Risk off

RORO can induce investors to follow a herd mentality depending on the risk environment. This type of investor behavior is particularly prevalent in times of economic uncertainty. The switch between high-risk and low-risk investments was very pronounced in response to the financial crisis of 2008/2009.

There are times when markets move dramatically in one direction or another as a result of either market-related or exogenous events. A risk-on/risk-off market environment shows the reaction of the market to a specific event and that reaction can last a day, a week or longer.

The way an event is perceived plays an important role in the markets. Sometimes the market is so firmly aligned that the publication of economic data cannot significantly affect the general trend, and the counter-trend movement is used by market participants to increase their initial position.

The Market Sentiment Determines Risk Tolerance

“Risk-on” describes a positive market sentiment. Investors are using riskier, higher-yielding investments. They are in a buying mood.

The opposite of this is “risk off,” meaning the mood in the market is not good and investors are looking for defensive stocks. There is demand for obviously lower-yielding investments whose risk is presumed to be lower.

  • Risk-on means that traders and investors are prepared to take risks and they are focused on the return on investment; risk-on asset classes are in demand and there is a strong correlation; in other words, greed is dominating the markets.
  • Risk-off means that traders and investors are risk averse and the focus is on preserving capital; risk-off asset classes are in demand and there is a strong correlation; in other words, fear is dominating the markets.

Definition of Risk-On

The term basically refers to the market sentiment in which investors are willing to take risks. In a risk-on market environment, riskier asset classes such as stocks will rise, while investments in “safe havens” such as gold or the Japanese yen will fall. The prices of government bonds such as the Euro-Bund-Future or T-Notes will also fall, and interest rates will rise.

The market participants are confident about the future prospects of the economy. Thus, they take their capital and speculate in the stock market and higher-yielding asset classes. This adds value to the stock market and high-yielding currencies, such as the Australian dollar (AUD) and the New Zealand dollar (NZD).

At the same time, low-yielding asset classes tend to rise proportionally much less or possibly even lose value.

The effects of market participants’ willingness to take risks (“risk-on”) include a rise in the stock market and increased demand for high-yield currencies. In this market environment, the carry trade strategy tends to perform well.

Risk-On Asset Classes

Definition of Risk-Off

Here we have the opposite of risk-on. Market sentiment is bearish; investors are fearful and unwilling to invest in riskier asset classes. One can expect the stock markets to fall considerably. The prices of gold and yen usually rise. The prices of government bonds rise and interest rates fall. The Euro-Bund-Future, which is traditionally seen as a safe haven, is a good indicator here.

Defensive stocks like utilities, consumer staples, etc. are sought after as these stocks have fixed dividends and stable income, which is not the case in the broader market. Defensive stocks have a beta value of less than 1 and perform better in a recessive market, and they perform worse than the overall market when the market is in an expansion phase.

Risk-Off Asset Classes:

  • Long volatility (VIX)
  • Fixed income securities (U.S. AAA corporate bonds, U.S. government bonds)
  • Low-interest currencies (Japanese yen, Swiss franc, but also the U.S. dollar)
  • Utility stocks
  • Gold

Where is all the money going?

So, the question arises of where all the money is going. This question allows us to assess whether investors are currently willing to take risks or whether they are risk averse, in other words: whether fear or greed is dominant, and we can use this assessment for trading. Which market segments are offensively aligned and which market segments are defensively aligned.

There are popular trades among investors, such as the “carry trade” or “long-short momentum” stock trades. The market alternates between risk-on times when money is going into these trades and risk-off times when money is going out of these trades.

A greatly simplified representation of these market trends could read like this: In a risk-on market environment, the increased demand means that profits from trades are higher and volatility decreases. This development means that more money is going into risk-on instruments. The increased prices make future earnings appear smaller, which encourages the use of greater leverage, which in turn leads to more demand. This scenario is turned around in risk-off times.

What happens in a risk-on market environment?

When the markets are functioning under normal conditions, many market participants try to increase their capital available through the use of leverage. Asset managers and individual traders and investors will buy or sell certain assets to take advantage of market volatility or price movement.

Many market participants will use leveraged derivative instruments such as futures, options on futures, ETF and ETN products and other trading instruments to maximize their profits. Leveraged products involve greater risk, but also have the potential for greater returns.

During the risk-on periods, the leverage (credit) in the markets will increase, as the majority of professionals and private investors consider the risks from the market itself or from outside to be low.

Risk-on periods have a high degree of liquidity; trading volumes are high and bid-ask spreads are low. In very liquid markets, it is easy to buy or sell to liquidate risky positions. Most of the time, market movements are dominated by risk-on periods.

Low-yielding currencies are sold to free up capital to buy high-yielding currencies. Selling a low-yielding currency and buying a high-yielding currency at the same time is called a carry trade.

What happens in a risk-off market environment?

A risk-off market environment means that the market sentiment is negative. When this happens, the traders/investors flee to currencies they perceive to be safe. The Swiss franc (CHF) and the Japanese yen (JPY) are currencies that are bought in a risk-off sentiment, as they are considered to be a safe haven. The USD/CHF and USD/JPY currency pairs would therefore move downwards.

A risk-off sentiment puts pressure on the U.S. stock indices, which also causes weakness in the global stock market. It’s no secret that global financial markets are strongly correlated. In particular, the stock markets of the emerging markets will show greater price losses, as investors buy reliable stocks and liquidate more speculative investments.

The USD/CAD currency pair is more likely to rise under these risk-off market conditions because the Canadian dollar is influenced by the oil market, which can drop in risk-off situations.

A classic example of these market movements was the U.S. presidential election on 8 November 2016. The election of Donald Trump was seen by the markets as a greater risk than the election of Hillary Clinton. Thus, the risk-off movements described above happened as more and more news in Trump’s favor was published. We experienced a risk-off market environment throughout the entire presidential race that lasted until election night. But, when it became clear that Trump would win the election, the market turned and instead of risk-off, there was now a risk-on sentiment. Specifically, the following movements occurred:

  • USD/CHF, USD/JPY, USD/CAD, stock markets rose
  • Gold and interest markets fell

A risk-off situation is bearish, in which the panic sentiment begins to dominate the markets. Usually, prices on the stock markets and commodity markets move faster in a risk-off market environment than if it is bullish, which is why traders have to react quickly.

Before an event that is considered risky by the brokers and banks, the margin requirements are increased. Extended spreads (bid-ask spreads) can also be expected, and stop loss and take profit orders can be executed with more slippage.

There are various reasons for the strong correlations and outperformance of certain “defensive” asset classes during risk-off events. Here are some of them:

Traders and investors use carry trade strategies that involve the purchase of higher-yielding government bonds in order to sell or finance lower-yielding government bonds with the proceeds. The interest rate difference is very clear, and it makes a difference even for retail traders.

Some brokers openly show the cost of carry for cross currencies such as EUR/AUD or AUD/JPY. If a retail trader is long in AUD/JPY and the position rolls overnight, they can benefit from the interest rate difference between the two currencies. If the trader is short on AUD/JPY and holds the position overnight, they will have to pay for the interest rate difference. And when there are problems in the markets, these carry trade positions are sold off as quickly as possible, which leads to higher correlations and higher volatility.

In these situations, long volatility instruments like the VIX benefit. In principle, even when local negative events (e.g. Brexit, Lehman crisis) occur, investors turn to safe havens and “defensive” investments, which can be fixed-interest bonds, as bondholders receive interest payments regardless of how the events develop.

Risk-Off and the Black Swan

Some traders refer to this type of risk-off period as a “black swan event.”

A black swan is an event that causes markets to move 10 standard deviations or more in a very short time. The 1997 Asian financial crisis and the financial crisis beginning in 2007 were both black swan events that dramatically moved the markets.

During these types of periods, many market participants will close all positions in order to get rid of risky positions. This risk-off scenario is usually quick and the price movement can be enormous as many traders and investors are operating at the same time.

During a risk-off period, prices can move even more than the triggering event implies, as liquidity falls and bid-ask spreads widen. In less liquid markets it becomes difficult and expensive to buy and sell or to get in or out of positions.

Black Swan Book Cover

Risk-off Periods in Commodity Markets

In the world of commodities, risk-off scenarios can cause enormous volatility spurts, as commodities have higher variances than stocks, bonds, currencies and other asset classes.

Commodities also often have higher standard deviations during risk-on times, so market volatility can get very wild when the market environment turns risk-off.

An example: the real estate crisis in the U.S. caused the crude oil future to fall from $147.27 a barrel in July 2008 to $32.48 in December of that year. This 78 percent drop in just six months is an example of the type of volatility that can occur during a risk-off period.

Risk-off periods are rare but memorable as the Black Swan events can result in huge losses. Wars, times of crisis, natural disasters and other exogenous events can be the causes of many risk-off periods in history. Since these events usually take the markets by surprise, it is difficult to prepare because, when they do occur, prices move dramatically.

Many financial institutions and regulators spend a lot of time understanding and preparing for risk-off events. Even private traders/investors should always have a plan of how they can protect their capital investments from a black swan, which can destroy huge amounts of capital very quickly.

Risk-On/Risk-Off Movements Have Changed

It is worth pointing out that risk-on and risk-off movements were different some time ago. They were defined in such a way that in a risk-on market sentiment the currency pairs EUR/USD, GBP/USD, AUD/USD and NZD/USD rose, while USD/CAD fell. In general, during this type of movement, the U.S. dollar was aggressively sold.

This market behavior changed when the central banks cut interest rates into negative territory and unusual monetary policy moves affected the currency markets.

The programs with expansive monetary policy of the central banks (quantitative easing) have disrupted the risk-on/risk-off sentiment around the world.

Under such programs, the central banks buy their own government bonds in order to generate inflation.

The markets have had to adjust to this new reality and today we see negative interest rates in many of the world’s major central banks. The purpose of a negative interest rate environment is to stimulate commercial banks to grant more loans to the real economy, which is intended to create jobs and economic growth. As the economy expands, so will inflation, and when that happens, central banks will return their monetary policies to normal. By then, the markets will have adapted to the new realities and the risk-on/risk-off sentiment will have been defined.

As a rule of thumb, you can remember that a risk-off trade exists when the riskier currencies are sold across the board against the Swiss franc and Japanese yen.

Final Comments on the Risk-On/Risk-Off Scenario

Traders can gain a competitive advantage when they know what to expect from a risk-on/risk-off perspective. This is very helpful in avoiding overtrading that could result from market correlations.

Find out more about risk-on/risk-off

Explanation of RORO Trades Video

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