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The Risk On/Off Concept

I often mention the concepts of 'Risk On' and 'Risk Off' approach to trading both stocks and FX and of 'correlation of FX pairs' throughout posts on this blog site.  I will attempt here to explain what these concepts mean.

 

Risk On Risk Off: This is often abbreviated as 'RORO':

 

'Risk Off':

This refers to periods when there is more fear in the market and investors want to pursue, or invest, in safe-haven type of trading instruments.  Examples of a safe haven currencies include the USD and JPY.  During periods of economic uncertainty the USD is viewed as a relatively safe-haven trading instrument and when traders buy the USD then the value of the USD increases. Thus, in 'Risk Off' periods, the USD usually rallies relative to most other currencies.  As a consequence the USD index, the USDX, increases as well. The Euro dollar index, the EURX, usually declines in 'risk off' periods. The Yen is also viewed, historically, as a safe haven instrument as is Gold. 'Risk off' periods are also usually associated with lower prices across many Stocks and the Stock indices of the S&P500, Dow Jones and NASDAQ.

 

'Risk On':

This refers to periods when there is more confidence in the general market and investors want to pursue more risky or progressive trading instruments.  An example of such a currency in Forex is the EUR, NZD, CAD and the AUD.  During these periods of confidence investors will often sell their 'safe' USD to buy the more risky or progressive instrument, such as the EUR or NZD etc, in the hope that they will benefit from a surge the latter's value.  The selling of the USD results in over supply and a fall in its value and the purchase of the AUD results in a demand and consequent rise in its value.  Thus, in 'risk on' periods, the USD usually declines in value relative to many other currencies such as the AUD or CAD. The USDX usually declines in 'risk on' markets and the EURX usually rises. 'Risk On' periods are also usually associated with higher prices across many Stocks and the Stock indices of the S&P500, Dow Jones and NASDAQ.

The correlations of the USDX, EURX, currencies and stock prices noted above are what is often, but not always, seen. That does mean that this correlation is permanent or fixed by any means. You do get periods where this correlation is tested when there is particular market volatility or during major global events. This is not a fixed metric that I use but one that holds true for a number of situations. I am always on the lookout for periods when this metric is being tested though.

This traditional RORO correlation has been tested since 2013 due to the many currency interventions by various Central Banks. An example of this has been the desire of Australia's Central Bank, The Reserve Bank of Australia, actively cutting interest rates in an attempt to bring down the value of the AUD. Thus, the AUD has lost much of its 'Risk On' trading status.

Correlation:
Please note that during 'Risk On' or 'Risk Off' periods that many of the pairs will move in a synchronised, or correlated, pattern.  For example, in a 'Risk On' period it is not unusual to see the AUD, CAD, GBP, SGD and EUR all increase similarly relative to the USD. Thus, in a 'Risk On' phase, the EUR/USD and AUD/USD will often move in the same direction.  We say then that these pairs are 'correlated'.  Please remember that you can check for the correlation ratio of FX pairs at the free site, Forex Correlation.  

Summary and Observations: 

There are periods of market activity that can be described as 'Risk On' or 'Risk Off' and these are characterised by the following patterns:

 

Risk On:

  • Falling USDX and rising EURX
  • Falling USD (often, not always)
  • Falling Bonds
  • Falling Yen
  • Rising EUR, CAD, AUD, GBP and NZD.
  • Rising Stocks 

In 'Risk On' periods I will therefore look to SHORT the USD and /or Yen and LONG the AUD, NZD, EUR etc.

 

Risk Off:

  • Rising USDX and falling EURX
  • Rising USD (often, not always) 
  • Rising Bonds
  • Rising Yen
  • Falling EUR, CAD, AUD, GBP and NZD 
  • Falling Stocks 

In 'Risk Off' periods I will therefore look to LONG the USD and / or Yen and SHORT the AUD, NZD, EUR etc.

I rely heavily on the indices, EURX and USDX, to help me assess the latest FX trend direction. This helps me with trading FX and with trading Stocks/Options.

 

Gold

The behaviour of Gold in 'risk on' or 'risk off' movement is not as easy to chart and predict. A falling USD often, but not always, results in a rise in the price of Commodities and Gold. Thus, a falling USD due to positive 'risk on' sentiment can see the price of Gold increase. Rising fear though, along with a rising USD can also see the price of Gold increase as people look to the metal as a possible store of value relative to all currencies. Thus, it is not always possible to relate market sentiment directly to the movement in price of Gold.

Classic patterns of correlation and RORO may well fade in future trading but it does not hurt to be aware of these historical patterns and alignments.