Risk off / Risk on

Often in the media you will hear the term Risk off or Risk on. Its more likely you will hear the term Risk off as financial media revel in the days where markets or risk assets go down in value and attempt to create as much sensationalism as possible to garner attention.

There was a time where during the financial crisis as the markets both tumbled and rallied each day with wreckless abandon that as a trading desk we were calling ” risk on ” ” risk off ” almost every hour.

The terms risk on and risk off relate to a portion of time in markets where investors are keen to either push their positions or the exact opposite and cut them. They are usually obvious in nature as markets become ” fast” or rapid price changes of a directional nature.

Here is where I get particular about the definition of risk off though. Risk off does not assume that investors just dump all risky assets and fly to safe assets. This often gets misconstrued in the media.

Global markets are made up of hundreds and thousands of investors, some very big and some very small. Everyone has different styles, risk tolerances, approaches, favourite asset classes and mandates for investing. What they do have in common though is that they all have risk of some sort. Positions to be more exact. They are either long or short an asset. Generally there is a long bias in the market for many reasons that I wont go into now but the important fact is that all these investors have money at stake in some shape or form.

Over time the collection of these positions will drift in price higher or lower and at some point cause a tipping point where there are too many over invested or under invested. This will generally lead to a reversal of fortunes good or bad for that asset.

When things get volatile like they have recently, investors are forced to consider the nature of their positions, some will be happy and do nothing, some may want to add to their positions but most will get caught up and look to de-risk and reduce their exposure.

Risk off is this process, it is the reduction of an investors exposure to the particular risk they are in.

That may sound general but please focus on the ” risk they are in”.  It is not an automatic move to buy less risky assets, if anything that would increase their risk as they are taking more risk on board.  It is a reduction of  the risk/ trades that investors are in.

This is always the most interesting part of markets as Warren  Buffet says ” it is only when the tide goes out you see who is swimming naked.”  Or to put it another way it becomes plainly obvious where investors have concentrated their risk exposure when things start to go against them.

It was noteworthy that a few days ago this exact situation happened. We just experienced a bona fide “risk-off ” situation where investors rushed to reduce their exposure to equities in particular. But while the equity market was causing all the excitement and carnage a few other assets were also giving a huge hat tip as to how people are/ were positioned.

Example one: EURUSD – The euro rallied VS the dollar: Traditionally the USD has been thought of as a safe haven currency- in times of strife, people move to cash and sit out in the USD as it still is the most used currency in the world. One would expect a large USD rally in such a panic situation then, however the absolute opposite happened. Why is this? There has been a large build of of investors who are already long dollars and more importantly short Euros. Therefore when everyone moves at once to reduce their own individual risk they are looking to sell their USD or cover their Euros.

Example 2: Oil rallied- Buying a commodity in a risk off situation in the past would lead to a one way ticket to bankrputcy as these are often considered the riskiest of assets. However the poor performance of oil over the last year or so has led to a build up of short positions. Again that means alot of individuals risk is in SHORT OIL. So a risk off move materialises in oil rallying.

There would be a myriad of examples in the equity markets of late whereby stocks that you would think are total dogs ended up rallying or at least out performing the quality names, again this is the same principle, the majority of investors would be short the ” dogs” and long the ” star performers” so much as they love/hate their risk, any move to reduce these risks will leave quite a few scratching their head.

In summary Risk off is a confusing time for the best of us, but if you can rise above the noise and look for clues that the market gives it will give you valuable insight into where investors are positioned across the markets. Also if you happen to be invested in something it is always good to assess where you think the broader market is positioned in your investment. If you feel they are with you then this can be a good thing but in times of risk off it should trigger a warning that you need to have a very itchy trigger finger to avoid the mess.

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One Response to Risk off / Risk on

  1. Pingback: Beatings WILL continue until morale improves | everydayeconomicsblog

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