In the world of trading, traders and investors tackle risk through two approaches – risk-on and risk-off. Both types of approaches involve following trends. Traders and investors closely watch market sentiment to predict market trends. So, they make a profit by trading with the trends. That said, it is also important for you to trade with trends if you want to make money.
AND to trade with the trends, you need to understand risk-off and risk-on approaches to tackle risk. If you want to know all about these concepts in trading, then you are on the right platform. Because in this article, we are going to explain risk-on and risk-off in detail. We will also explore you to modulate your risk appetite. So, keep reading this article and enhance your knowledge.
Risk-on vs. risk-off
Have you ever thought about why expert traders, investors, and analysts emphasize gauging market sentiment? The answer is to make a profit on both bullish and bearish trends in the market. They closely watch market sentiment to know about the direction of the wind.
Now, there are two types of environments you will find in financial markets. The first one is risk-on and the second is risk-off. A risk-on environment refers to the bullish approach of traders and investors. In other words, they are willing to take risks on their portfolios to make profits. Contrarily, a risk-off approach refers to the bearish approach whereby traders and investors prefer to protect their investments.
Risk-on means the market environment in which traders and investors prefer to take high risks. That means they buy riskier asset classes such as stocks as compared to low-risk assets like gold. In simple terms, risk-on refers to a positive market sentiment that leads investors to focus on their return on investment. Therefore, they prefer to invest in riskier but high-yielding financial assets to make more money.
The risk-on market environment refers to the tendency of traders and investors to take high risks. They go into buying mode and invest in riskier assets to increase their return on investment. That means, riskier asset classes such as stocks are in high demand during risk-on market sentiment. But the question is what makes investors take high risks?
It is the future prospects of an economy that makes investors take higher than usual risks. They feel confident about the economy and therefore, turn to risky but high-yielding asset classes. As a direct result of investors’ sentiment, stock markets as well as other high-yield financial markets rise.
Risk-on asset classes
- Stocks (with high price-earnings ratio)
- High-yielding Forex pairs such as the Canadian dollar, New Zealand dollar, Australian dollar, etc.
- Industrial metals like aluminum, copper, etc.
- Energy commodities such as crude oil
- High-yield bonds
Risk-off refers to the market environment in which traders and investors prefer not to take risks. Contrarily, they prefer to protect their investments. That means they buy low-risk asset classes such as gold as compared to high-risk assets like stocks. In other words, this approach refers to a negative market sentiment that leads investors to focus on preserving their capital. Therefore, they prefer to invest in less risky and low-yielding financial assets to make more money. For example, they invest in defensive stocks such as staples, utilities, etc.
The risk-off market environment is characterized by bearish sentiment. Traders and investors try to minimize risk exposure as much as possible. In fact, they prefer to sell risky assets and invest in more safe and low-risk assets. Moreover, this type of environment in the market generally appears during recessions. Investors don’t see the economy on the right path and therefore, go into a more defensive position to protect their capital.
Risk-off asset classes
- Staple and utility stocks
- Low-yielding currency pairs
- Metals like gold
- Government and AAA-rated corporate bonds
- Money market funds
How to modulate risk appetite?
To modulate your risk appetite, it is imperative to understand when market sentiment changes. It is important because determining trends and following trends are prerequisites to profitable trading. Is it easy to determine whether it is risk-on or risk-off sentiment in the market? The answer is yes. It is easy to identify whether it is risk-on or risk-off sentiment in the market. How so? Let’s see how.
As you already know, the risk-on market environment is characterized by bullish sentiment in the market. That means traders and investors are in a buying mood. They willingly take excessive risks to make more money. So, the demand for high-yielding asset classes significantly rises. For example, you will find stock prices rising and even setting all-time highs. Why so? Because high demand pushes prices high. Similarly, most traders and investors also turn to other high-risk assets to earn profits.
So, can you emulate those experts to make money? Can you also modulate risk appetite? Yes, you can but you should know the trick. The trick is to understand when market sentiment starts to change. For example, when risk-on begins to overpower the risk-off market environment. It helps you stay ahead of the market, take the risk with great measures, and make money. Here are a few signs that may help you understand whether it is risk-on or risk-off sentiment in the market.
Risk-on market environment characteristics
- High demand for high-yielding assets
- 50-day moving averages cross above 200-day moving averages which suggest prices are heading high
- Gold prices are stable to begin to decline
- A High-low index above 70 indicates the majority of stocks are trading near highs
- Volatility index declines
- Bond yields increase
Risk-off market environment characteristics
- High demand for less risky asset classes
- Increased demand for staples and utility stocks
- 50-day moving averages cross below 200-day moving averages which suggests prices are heading low
- Gold prices are beginning to increase dramatically
- A High-low index below 30 indicates the majority of stocks are trading near lows
- The volatility index increases and traders move to protect their investments
It is important to note that these indicators are not accurate in all circumstances. Therefore, it is important to make trading decisions with great caution. However, if you monitor numerous indicators like that, you can easily determine market sentiment.
When more indicators suggest a bearish trend in the market, you should be defensive and minimize risk. Conversely, if indicators suggest a bullish sentiment, you can take a more risky approach to make more money.
All expert traders, investors, and analysts spend their time and energies on gauging market sentiment. Why do they do so? They do it to determine upcoming market trends and follow those trends to make money.
There are two main types of the market environment as far as risk-taking is concerned. The first one is the risk-on approach. It involves taking high risks to make more money. Traders and investors focus on riskier but high-yielding assets to make money. Conversely, there is the risk-off approach. It involves being defensive and investing in less risky asset classes. During a risk-off market environment, traders and investors prefer to protect their investments.
It is very crucial for all traders and investors to determine market sentiment or changing market sentiment. By doing so, they can easily determine when they should take high risks and when to go defensive. This should be your plan of action to stay on the right side.