What Is a “Risk-on” Trade?

10/25/2011 9:45 am EST

Focus: FOREX

Boris Schlossberg

Managing Director of FX Strategy and Co-Founder of BKForex LLC, BK Asset Management

The terms "risk-on" and "risk-off trade" have been more mainstream of late, and Boris Schlossberg defines each one, providing examples of what is in play under each condition.

In the trading and investing world, you’ve probably heard the terms “risk on” and “risk off,” but what does that mean? Our guest today is Boris Schlossberg to talk about that.

Boris, first of all, can you define what “risk on” and “risk off” means?

Generally, in a market, risk appetite or risk assets are ones that are highly correlated with the rise in the equity markets. Basically, the idea is this: When investors feel good about the future, they feel positive about equities, they invest in equities, and equity prices across the world rise.

Also, commodity prices across the world rise, so any asset that’s linked to commodities, to equities, rises with it.

In the currency world, that translates to currencies that have high yield, like the Australian dollar, the euro, the Canadian dollar, relative yield to the rest of safe-haven currencies like the Swiss franc or the Japanese yen, or even the US dollar.

Those currencies seem to perform very much in sync with the rise in risk appetite. When we’re talking about risk on, in effect, we’re talking about those types of currencies that are rising when things are good, and risk off, the dollar, the Swiss franc, the yen, (that are) rising when things are bad.

So when people are willing to take risk, they flood their money outside of the US, outside of the US dollar, outside of those kinds of safe assets?

Yes, and the reason why is because those currencies, of course, produce higher yields. Therefore, they are by definition presumed to be a little bit riskier. It all assumes the idea that further economic growth will produce even higher yields in those currencies, so that’s why you have this self-fulfilling cycle of virtuous rise.

On the other hand, when investors really pull in their horns, that’s exactly the opposite effect and everybody starts to sell those currencies and you have a complete collapse of those values.

Typically gold and some of the metals have been safe-haven investments or a risk-off type of an investment?

Correct, ironically enough, gold has been viewed that way, but if you look at it really over the last several years, it’s also been very highly correlated with risk-on ideas.

Because gold effectively is a commodity, and remember that commodities and equities tend to be running lockstep together. Whenever global appetite is positive, they tend to rise, so gold has actually risen with global appetite, and it has now recently fallen, as we’ve seen, because we’ve had a massive collapse in the equity markets.

That’s had a big negative impact on the Australian dollar, the Canadian dollar, all the risk-on currencies that are commodity linked.

Oil, which has collapsed below $80 per barrel; and gold, of course; and silver, which have had massive declines recently, all because of these types of dynamics.

NEXT: Is US Dollar the Real "Safe-Haven" Investment?

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We also hear that the Swiss franc is a safe-haven currency, but then some people say because the US may default—we’ve had those issues previously—and yet it doesn’t matter. Whenever there’s a risk-off type of environment, they come flooding back into the US.

Right, because if you think about this, there is no currency more liquid in the world than the US dollar.

Switzerland is a very good economy, very tightly run operation, but it’s tiny; it’s absolutely tiny. It’s impossible for the Swiss to absorb all the global capital, but it’s not impossible for the US to absorb most of the global capital when there is fright in the air.

So the dollar becomes a tremendous beneficiary of risk-off flows whenever these kinds of dynamics happen.

Finally, how do you see this risk on/risk off playing out into the end of 2011 and maybe into 2012?

I definitely think that we probably still have a little bit more pain to go forward. It’s clear that we’re starting to see signs of a global economic slowdown, and equities of course front-run that dynamic and they tend to anticipate those moves, so we’ve had a tremendous selloff already there.

I will say that I think long term, I’ve been a long-term bull on gold for a very long time, because what we’re seeing across the world is a continuous devaluation of currencies, continuous money printing, and I think those effects are not going to go away anytime soon because of the massive amount of debt that we all have been able to sustain across the world.

These opportunities when we have the risk-off selloffs in gold that are essentially driven by lots of liquidation and lots of margin call. One of the other things that happens, the reason why gold, for example, sells off is because people lose money in equities and then need to raise money quickly, so they sell off gold simply because they have to, not because they want to.

It really presents a very interesting opportunity for investors to come in and buy on the dips.

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