Risk sentiment is a term used to describe how financial market participants (traders and investors) are behaving and feeling.
What traders choose to buy or sell means balancing how much they are prepared to lose with how much they hope to earn.
You can look at risk sentiment as the expression of traders’ and investors’ willingness to take on risk.
This means understanding risk and the collective markets’ attitude to risk, which how much risk you are prepared to take with your money and assets in a particular timeframe.
Think of risk sentiment as the mood of the overall financial market.
Risk can be defined as the exposure to the chance of injury or loss.
When you have a position open in the market, you are, by definition, taking on risk because there is a chance that your trade results in a loss.
The financial markets play on the risk sentiment of traders, given their vulnerability to the two primary emotions that drive their decision-making:
Since a great deal of financial market activity is based on short-term speculation, meaning trades can be entered and exited quickly, risk sentiment is an important concept for traders to understand.
Risk sentiment is used to describe the behavior of traders and investors.
Are they “seeking risk“?
Or are they “seeking safety“?
You’ll often hear the terms “risk on” and “risk off” thrown around in the financial media.
When the market is “seeking risk”, it is considered a “risk on” environment.
Risk is “on” when the economic outlook is optimistic, incoming economic data is supportive, and markets are exhibiting low-to-normal levels of price volatility (both up and down).
A “risk on” mood refers to traders’ willingness to make riskier trades.
In a “risk on” environment, traders and investors feel more confident and will seek higher returns by buying “risky assets” and selling”safe haven” assets.
They rotate their capital into risky assets.
Usually, the higher the risk you are willing to take, the higher the potential returns could be. BUT equally, the higher the risk of losing your money also.
Risky assets include stocks, commodities, precious metals, and higher-yielding currencies, which range from major currencies like the Australian dollar (AUD) to emerging currencies like Brazilian real (BRL).
When the market is “seeking safety”, it is considered a “risk off” environment.
Risk is “off” when the economic outlook is poor or deteriorating, economic data is disappointing or downright negative, and markets are exhibiting high levels of price volatility.
Unanticipated or sudden negative events, such as a global financial crisis (such as the Great Financial Crisis in 2008), a global health crisis (such as the Coronavirus Criss in 2020) disappointing economic data, geopolitical turmoil (such as the ongoing Middle East conflict), political scandals, election results, and natural disasters, can shift market sentiment to risk “off”
A “risk off” mood refers to traders’ reluctance to make riskier trades.
When traders become “risk averse”, they tend to take two actions:
- Sell (exit positions) in “risky assets”
- Buy (enter positions) in “safe haven assets”.
In a brutal market environment, traders/investors seek out “safe havens” that are relatively more insulated if economic conditions worsen.
They rotate their capital into safe have assets.
These lower-risk assets offer lower rewards but have less risk attached too.
Safe haven assets are seen as the best way to preserve capital during periods of “risk aversion” or panic.
The ultimate safe haven asset is cold hard cash.
If cash isn’t your cup of (safe haven) tea, other examples of safe haven assets include U.S. government bonds, Japanese yen (JPY), Swiss franc (CHF), U.S. dollar (USD), and gold (XAU).
For stock traders, stocks in companies that are part of the health care, utilities, and consumer staple sectors are also considered as safe haven or “defensive” assets.
This is because companies in these sectors provide products that people need regardless of the economic landscape.
Why is risk sentiment important?
Being aware of risk sentiment helps you preserve capital and manage risk and emotions.
The daily or weekly ups and downs of markets frequently reflect shifts in risk sentiment.
By knowing this, you’ll be able to better understand why the market is acting the way it is.
You’ll be able to stay calm and understand events, interpret news, and analyze economic data. All in a clearer light.
Keep in mind that shifts in risk sentiment can happen either gradually or quickly.
Markets can be in “risk on” mode for days, weeks, even months, only to quickly switch to “risk off” mode.
Viewing market news and data through the lens of risk sentiment cuts through much of the ambiguity or complexity of individual events.
When you see a news headline, ask yourself “Is this positive or negative for risk sentiment?”
The significance of the news will determine how much risk sentiment will shift.
For example, a disappointing minor economic data release, in an overall improving economic environment, may result in little to no effect in the current risk sentiment.
In this case, the markets simply ignore the data and continue to buy risky assets.
In another example, a larger-than-expected negative result in a major economic data release (such as the NFP) against a deteriorating economic environment, may have a huge effect on risk sentiment.
As risk sentiment shifts from “risk on” to “risk off”, capital would rotate from risky assets to safe haven assets.
This would trigger a sudden sell-off in risky assets and a rally in safe haven assets.
When the markets are in “risk off” mode, the bears will be out on the prowl.
At best, the price action will be subdued, preventing any meaningful upside. At worst, prices will be falling faster than a failed Space X rocket test flight.
How do I measure risk sentiment?
In order to use risk sentiment in your trading, you have to know how to find it. Here are four things to monitor to know whether you’re in a “risk on” or “risk off” environment.
U.S. Stock Indexes
The U.S stock market indexes are among the most obvious real-time barometers to watch.
The three most widely followed indexes in the U.S. are the S&P 500, Dow Jones Industrial Average (DJIA), and NASDAQ Composite.
These indexes act as indicators not only for the U.S economy but for the global economy as a whole.
If the stock indexes are up, risk is “on”.
If the stock indexes are down, then risk is “off”.
To help measure the degree of risk “on or off” in stocks, you look at the VIX Index, also known as the “Fear Gauge” or “Fear Index“.
A volatility index is a measure of a particular market’s likelihood of making sudden, unexpected price movements, or its relative instability.
It is the most well-known volatility index on the market, and.commonly used by stock and options traders to gauge the market’s anxiety level.
The VIX Index measures market expectations of future volatility in the S&P 500 index.
The higher the VIX moves, the more fearful the market. The lower the VIX moves, the less fearful the market.
If VIX gives a value of greater than 30 then the market is seen as volatile, while under 20 is believed to be calm.
U.S. Government Bond Yields
Government bonds are issued by governments to raise money to finance projects or day-to-day operations.
In the U.S., the U.S. Treasury Department issues bonds throughout the year and are known as “U.S. Treasuries“.
Since U.S. Treasuries have the backing of the U.S. government, they are considered as close to risk-free as an investment can get. Hence, why they’re considered as safe haven assets.
The U.S. government offers three types of fixed-income securities to fund its operations: Treasury bills, Treasury notes, and Treasury bonds.
Each type of security has a different rate at which it matures ranging from 4 weeks to 30 years, and each pays interest in a different way.
The financial media also reports on the yields of the different U.S. Treasuries.
If the yields are up, this means that the market is selling U.S. government debt. (Selling bonds causes their prices to fall which increases their yield.)
If folks are selling such a risk-free asset, they’re probably feeling optimistic, which means the sentiment has shifted to”risk on”.
If the yields are down, this means that the market is buying U.S. government deb. (Buying bonds causes their prices to rise which decreases their yield.)
If folks are buying U.S. Treasuries, they’re probably feeling scared, which means the sentiment has shifted to”risk off”.
Safe Haven Currencies
Currencies are usually the most sensitive to risk sentiment. When sentiment shifts, “safe haven currencies” react swiftly.
Safe haven currencies are currencies that are expected to retain or increase in value in a “risk off” environment.
What’s great about the forex market is that it’s open 24 hours a day during the week. This means that you can monitor risk sentiment even when the U.S. stock market is closed.
Strength in the U.S. dollar is an indicator of “risk off” sentiment.
If the U.S. dollar (USD) is stronger against higher-yielding currencies, markets are likely not happy about recently released economic data or news.
If that’s the case, then their response would be to seek the safe haven of the U.S. dollar.
Foreign investors may also be looking to buy U.S. Treasuries as a safe haven, and in order to buy those, you need USD.
If you don’t have any USD, then you have to buy some When lots of investors do this all at once, this causes USD to rise.
The Swiss franc is another currency that is considered as a safe haven currency.
Political stability, sound fiscal and monetary policy, and a steady economy make the CHF a safe haven currency to which international investors return in times of crisis.
Despite the many crises that have occurred in the past in the global financial markets, Switzerland has always managed to hold firm without too much trouble.
If the Swiss franc (CHF) is stronger against higher-yielding currencies, there is market turmoil somewhere, probably in Europe.
If that’s the case, then currency traders will flee to the perceived safety of the CHF.
Such price action from CHF would indicate a “risk off” environment.
Strength in the Japanese yen is another indicator of “risk off” sentiment.
If the Japanese yen (JPY) is stronger against higher-yielding currencies, markets are likely not happy about recently released economic data or news.
Especially if it’s data or news related to the United States.
If that’s the case, then their response would be to seek the safe haven of the Japanese yen.
Specific currency pairs to monitor are AUD/JPY and NZD/JPY due to their popularity as carry trades, which is considered a “risk on” type of strategy.
Sudden drops in AUD/JPY and NZD/JPY signal risk aversion.
When there’s a lot of uncertainty in the world. there is usually a “flight to safety” to JPY (and USD and CHF).
If you start AUD/JPY and NZD/JPY rise though, this suggests that risk sentiment has shifted back to “risk on”.
Nothing is totally safe.
Just to be clear, there is no such thing as a 100% risk-free asset to escape to.
It is inaccurate to think there is a “permanently safe” asset. It’s impossible to be truly “risk off”.
Even if you are in cash, you risk inflation slowly eroding your purchasing power.
“Risk on” and “risk off” are simply terms to describe the mood of market participants which influences what they buy and sell causing certain assets to significantly rise or fall in price.
There is always risk.