Risk sentiment

by FinancialSource.co
Updated: August 27, 2020

An analysis of risk sentiment, how to identify it and how to actually go about to trading it.

Traders are emotional beings and the way they feel (optimistic, uncertain, pessimistic) is a key factor in determining their actions (buy, hold, sell). Since the market as a whole is made up of traders, risk sentiment is essentially “the mood of the market” and is an indicator of its appetite for risk.

Risk-on, risk-off

When traders are feeling bold and that everything in the market is wonderful they usually rotate towards riskier assets, away from safer but less exciting assets. We call that risk-on sentiment.

Conversely, when traders are feeling uncertain and fearful they will tend to rotate away from riskier assets and towards safer ones. We refer to that as risk-off sentiment.

How to identify risk sentiment

When we evaluate risk tones, we need to analyse all of the major asset classes in order to figure out where the money is flowing.

Starting with equities as a general guide is always a good idea because they are relatively high risk.

Due to the higher volatility of equities we often see them react quickly to sudden changes in the overall risk appetite.

When we have a strong risk appetite - a risk-on tone - we expect strength for global equities across the board. And when we have very low risk appetite - a risk-off tone - we would expect to see weakness for global equities.

Keep in mind individual factors that can dramatically affect the prices of individual stocks away from risk sentiment. Earnings reports, geopolitical issues etc., need to be filtered out especially when we see big moves in the equity market.

Commodities are also generally considered to be riskier assets but the situation here is complicated by certain commodities that go against the trend. Oil and copper are good examples of higher risk assets and the most notable exception is gold which is treated as a safe haven in times of uncertainty.

We generally expect a risk-on tone to be positive for oil & copper and negative for gold whereas a risk-off tone should be negative for oil & copper and positive for gold.

As with equities, there are individual factors beyond risk sentiment that can drive the prices for specific commodities especially if they’re used extensively in manufacturing (such as oil & copper).

We should then continue the analysis to include government bonds which (for all the stable governments) are considered to be some of the safest investments and are inversely correlated with risk tone.

When we extend the analysis to include currencies we have to be especially careful to identify which are considered riskier (typically AUD, NZD, CAD) and which are considered safer (typically USD, JPY, CHF).

How to trade risk sentiment

When we’re looking at a market with strong risk-on sentiment we can expect that assets classified as higher risk will increase in value across the board and that safer assets will perform relatively poorly. When it’s risk-off we can expect the opposite.

This is especially useful when we’re trading Forex because we can pair strong currencies with weaker ones, e.g. buying AUDJPY during risk-on and selling it during risk-off.

Another key to trade risk sentiment is to look for a change in it.

Having identified the prevailing risk tone of the market we can look at volatility indicators such as the VIX so we can predict where the market will go.

Important things to remember

  1. Risk sentiment is never just one thing which is why we always need to look at a range of asset classes.
  2. Like most correlations, risk sentiment it isn’t perfect and it should be treated as an indicator not a rule.
  3. Risk sentiment is driven by emotion so it can change quickly and sometimes contrary to what is expected rationally.
  4. When risk sentiment is hard to identify it’s use for planning trades is limited, but when it is clear & significant (in either direction), there are often great opportunities for those who act quickly.

More info

You can explore the VIX on tradingview.com

The accompanying video, “The Ultimate Guide To Risk Sentiment” from FinancialSource.co is embedded below:

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