Risk-on vs. Risk-off Trading

04/06/2012 2:10 pm EST

Focus: TRADING

Corey Rosenbloom

Founder and President, Afraid to Trade

Corey Rosenbloom explains what is meant by “risk-on” and “risk-off” trading conditions and which markets are associated with each of these situations.

My guest today is Corey Rosenbloom and we’re talking about “risk on” and “risk off” and what those terms mean to you as a trader.

So, Corey, We hear these terms all of the time, but what do we mean by “risk on” and “risk off?”

Let’s start with risk on, because that’s more enjoyable to talk about. We like when markets rise. Risk-on markets would be ones that we would call bullish, or when people want to put on risk to make money.

With risk, we think of it in terms of losing money, but one puts on risk to make money. So things that rise with good news.

Risk-on markets will be defined as stocks, in general. They are more risky than an opposing market, which is bonds. That’s risk off.

If you are bullish about the future, you might put more money into the stock market. If you are bearish about the future, you will probably put money into bonds. That’s risk off.

But it goes beyond that. Traders, funds, and hedge funds use multiple markets for cross-market movement, hedging strategies, or just for mitigating risk. So what they do is look at the different market structures or different markets themselves.

So for example, the simplest is stocks as risk on and bonds as risk off, but commodities come out with the risk-on markets. For example, crude oil, gold, and silver; those are also sensitive to economic conditions. When economic conditions improve, those markets rally as well, so we can consider commodities as risk-on assets, in general.

The opposite will be true about the dollar index. It tends to be a safety play. The US government is seen as safe, and people see the dollar as a safety play. It’s often called a safety hedge, so in periods of market turmoil like the market of 2008, really the only market that did well was the dollar index. Bonds actually rallied later in the August/September period, but in terms of risk off, we’re looking at that.

See related: 2 “Safe Havens” That Aren’t So Safe

So in general, to our definition, we are looking for stocks, commodities, and maybe the euro to be the risk-on style markets, and risk-off markets would be for safety or protection. Things you go for to hedge, which would be bonds, maybe the US dollar, or other markets that are less volatile and not as “risky.”

NEXT: How to Respond to Risk-on/Risk-off Shifts

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If I hear that it’s a risk-on environment, does that necessarily mean I should be in stocks, or if it’s risk off, I should avoid stocks, or is it just something to keep in mind while I’m trading?

It’s to keep in mind, but it depends on your style. If you are an investor, we go risk on and risk off sometimes on a day-to-day basis, and that’s very confusing for longer-term investors. Most of the time, a risk-on procedure would last for a few weeks, or maybe a month.

For intraday traders, it is far more important to look at these markets on this sort of basis, and there is even what we would call the “one-market thesis,” where all of these markets have approached higher correlations and move together.

In the past, these markets were a little bit different. They were more divergent. You did not have these things where risk-on markets all moved higher on an intraday, day-to-day, or weekly basis as you have today.

See related: The Myth About Oil/Stock Correlation

So for an intraday trader, yes, it is very important to be able to understand what risk on means and how to look at charts on higher time frames. When funds move into risk management, and when they shift from a more protective environment, that would signal risk-off conditions.

The VIX is always talked about as the “fear indicator.” Does that have something to do with risk on and risk off?

To an extent, yes, and traders actually can use that. It’s not so much a market like commodities or stocks, but it’s a volatility index that can now be traded using ETFs or futures, and so people can use that as their own hedge.

For example, if they’re holding good stocks for the long term, but they expect a volatile period of maybe a month to a month and a half, or even shorter in this kind of environment, they may trade VIX options because the VIX will rally. Being a fear index, it’s based on option premium, so the general index will rise as the market falls. When fear enters, or as hedging takes place, option premium goes up; therefore, the volatility index goes up.

That’s correlated to markets and how markets fall faster than they rise. People tend to be much more fearful quicker, and at the same time, it’s more emotional when the markets plunge. Therefore, volatility can rise much more quickly when the market falls.

We traders say, “The markets take the stairs up and the elevator down.” That ties into risk management and risk on/risk off. It is much more likely to have a sudden surge toward risk-off assets than it is to surge quickly and powerfully into risk on.

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