RORO stands for “Risk On, Risk Off”.
RORO describes a market environment where price behavior responds to and is driven by, changes in risk tolerance by investors and traders.
The change in risk tolerance is usually due to a sudden shift in the global economic outlook.
Traditionally, financial assets were evaluated independently of each other according to their unique characteristics. So for the most part, assets moved independently of each other.
In the RORO era, times have changed.
Financial assets are now simply split into two camps:
When optimism is high. market participants turn their risk switches “on” and moved into riskier asset groups.
This means that during periods when risk is perceived as low, traders tend to buy higher-risk assets (“risk on”).
When risk is perceived as high, traders tend to dump high-risk assets and buy lower-risk investments (“risk off”) instead.
So if optimism turns into pessimism, market participants turn their switches to the”off” position.
And, as a herd, they retreat into safe haven asset classes.
This meant assets tend to become correlated with each other, either positively or negatively, rather than moving independently of each other.
“Risk On” Assets vs. “Risk Off” Assets
Here is a cheat sheet on which assets are bought or avoided during “risk on” and “risk off” environments.
|Environment||Long||Short or Avoid|
The “RORO Trade”
The theory behind the RORO is the tug of war between inflationary and deflationary forces.
- When inflationary forces are perceived as gaining ground, then “risk on”.
- When deflationary forces are perceived as gaining ground, then “risk off”.
The effect of the “Risk On, Risk Off” is greater volatility and, most importantly, greater asset correlation.
Since the Great Financial Crisis in 2008, there has been a growing trend of market participants, particularly institutional investors/traders, to buy risk (“risk on”) when inflation is the leading expectation for the economy and sell risk (“risk off”) when deflation is the leading expectation for the economy.
Since all these market participants are making similar types of trades, it’s sometimes called the “RORO Trade”.
This mass movement of large financial institutions, hedge funds, and traders going “all in” or “all out” of asset classes has caused many assets to become highly correlated.