What is Risk-on and Risk-off?
One aspect that is crucial to making educated and well-informed trades is that of “Risk-on risk-off.” Risk-on risk-off (RORO), refers to changes in investment activity in response to global economic patterns. It is an investment setting where price behavior is driven by and responds to alterations in investor risk tolerance.
During times when the risk is perceived as low, traders tend to engage in higher-risk trades. There is an increase in the stock market, and a demand for high yielding currencies. Commodity prices benefit and the market expands to strong future economic growth that will benefit those commodities.
When risk is perceived as high, traders naturally engage in lower risk trades. Throughout these times, investors pull their money out of stocks and sell their high-yielding currencies. Treasuries and German bonds generally become very popular as they are seen as risk-free.
First gauge the sentiment
As a trader, you should first figure out what the sentiment is, and then pick a trade that communicates well with the sentiment (either risk-on or risk-off). The goal is to create a trade that aligns with the sentiment. For example, it is smarter to look for a long position in the S&P 500 while we are in a risk-on mode.
This table portrays the ways certain asset classes are affected by risk-on and risk-off situations:
|Stocks||When risk is on for stocks, they go up.
|When risk is off for stocks, they go down.
|Government bonds: US10Y, Germany Bund, Italy||When risk is on traders are generating demand in higher risk bonds; for example, Italy and Greece can sell bonds of stronger countries like the US and Germany.
|When risk is off for government bonds people invest in lower-risk bonds; for example, Germany and the US can sell bonds of weaker countries like Italy and Greece.
|Corporate Bonds||Money goes out of corporate bonds due to the risk
|Money goes into corporate bonds due to the lack of risk
|FX: USDJPY||USD/JPY tend to trend higher in the risk-on environment.
|USD/JPY tend to trend lower in the risk-off environment.
|When risk is on commodities such as oil increase because projected economic growth implies greater future demand for oil.
|When risk is off commodities such as oil decrease because projected economic contraction implies less future demand for oil.
|Precious metals: Gold, Silver||As risk-on occurs, demand for safe assets like Gold and Silver decrease.
|As risk-off occurs, demand for safe assets like Gold and Silver increase.
As traders, it is useful to first recognize if the situation in the market is risk-on or risk-off, and then to look for trades that are supported by this sentiment. Not all the commodities that are on the same side of the table above trend in the same manner. Therefore, it is important to pay close attention to each individual commodity and try to understand the flow of money between the asset classes in each mode of the market.
Some good practice could be to ask yourself before entering a trade:
- What is the sentiment now – Risk-on\Risk-off?
- Is my trade aligned with this market mode?
These practices could significantly help you to determine which side of the market you like to be on. Only after figuring out the exact trade and the direction favored, can the entering and exit point become much more clear cut. As this article shows, sourcing the risk-on/off is a significantly effective approach to your trading and can greatly impact the effectiveness of your trades.
The tool: REAL-TIME MARKET SENTIMENT