DailyFX Tips & Picks: Why traders should care if the market is risk on or risk off

WHEN trading, you often hear the expression “risk on/ risk off”. It’s a quick way of explaining whether the market is happy to take more risk by buying high yielding currencies, or to reduce risk exposure by shifting assets to cash and bonds – which usually means buying the US dollar and Japanese yen.

In a “risk on” state, investors look to buy the currency of the country which is expected to perform the best relatively. You want to pinpoint which central bank is likely to raise interest rates first. Today, people are buying sterling, as the UK economy is doing well and the Bank of England will be forced to raise rates sooner rather than later. We will know that we are in a “risk on” mode if global stock markets trade higher.

In “risk off”, traders don’t care about returns, they only want to keep their assets safe. This means they will sell high yielding currencies and shift to currencies with the lowest yields – the “funding currencies”, usually the US dollar and the yen. The reason is that investors will usually borrow money cheaply in the funding currencies, and then invest it in the high yielding currencies. This is the famous “carry trade”. In a risk off situation, stock markets will be usually trade lower.

As risk subsides, and the valuation of the high yielding currencies becomes attractive, markets will turn to a “risk on” mode. In this situation, traders don’t care if it’s the US or Eurozone that is doing relatively better. As the whole world is expected to benefit, investors will buy all risky assets. This happened at the end of 2012. US macro reports were exceeding expectations but people still bought the oversold euro. People that did not know about “risk on/risk off” learned the hard way.

Alejandro Zambrano is a currency analyst at DailyFX. Twitter: @AlexFX00