What Determines "Risk-On" And "Risk-Off" Sentiment?
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What Do Risk-On and Risk-Off Sentiment Mean?
The aspect of risk changes according to the given market circumstances. Sometimes, a play would be considered more risky at that point in time, and other times, it would seem like a safer bet. Risk-on can occur in times of economic prosperity, as in when taking riskier bets are more likely encouraged. In the stock market, risk-on sentiment happened earlier this year after indices fell by a record decline and the Fed announced its stimulus plan. When the Treasury began printing trillions of dollars, the Fed bought in the market, causing an overall surge in prices. That would be an example of a risk-on environment. Investors know that the companies they love are backed by the Fed and will continue to buy shares with a seemingly endless amount of money. We watched as Tesla shares went from $360 to $1,000 in a matter of three months. The Nasdaq reached all-time highs, erasing all losses for the year and more.
Risk-off is when investors avoid the riskier bets, like the stock market, and move towards so-called "safe havens" that won't be extremely volatile. When markets are more uncertain and volatile, people tend to move towards risk-off plays. Let's say the USD is way overvalued and very volatile. Investors might look towards moving their money to gold which is more of a risk-off trade. Overall, if traders are selling and seeking shelter in other things, that is how you know we have switched to risk-off.
Comparing Risk-On Risk-Off
During risk-on environments, potential gains could be massive due to a high sentiment in something. But the catch is that losses can be just as bad. However, if a market is considered risk-on, there is a higher probability that companies will do well and investors will be profitable on their positions. Risk-on is for high yields and general high risk appetite due to confidence.
In risk-off environments, returns are not expected to be high. Usually, returns are very low. General risk tolerance is low as investors just want their money to be safe in the meantime. Although risk is avoided for the most part, investors won't see the gains as risk-on, but their money will be safer. US Treasury bonds have a very low yield on returns, but it's a place to go when the market is selling off and/or there is great uncertainty.
How to Spot Risk-On/OffMarkets
One way investors look for risk is through very big news or other indicators. A good risk off indicator in forex would be high interest rates. The value in any type of currency pair would become risk-off if the country's rates were high. High rates means holding your money will pay you capital regardless of where the price moves. And during a period of low interest rates, risk-on becomes a factor.
Another way investors look for risk is through the VIX, or the "fear index". The VIX is supposed to measure volatility in the market. If the VIX is high, there is a high volatility, meaning there is high uncertainty. More people are afraid to invest when the VIX spikes, and vice versa. In low volatility, risk-on becomes the sentiment. Within the past couple months, the VIX came down hard as investors poured their money into the stock market.
The differences between the two sentiments are extremely important and useful to know when you are trying to trade/invest in currencies, stocks, indices, etc. These behaviors derive from the overall risk tolerance of traders. Economic changes, updates, or patterns, will all reflect the behavior of the market, and hopefully you will be able to use risk-on/off to your advantage.
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