In the wake of Wednesday's broad-based "risk off" trade in many markets (high-yielding currencies, gold, oil, stocks, etc), I wanted to take an opportunity to repost an article I recently wrote on risk sentiment and diversification. Note that lately the Swiss Franc has not been trading as a safe haven whatsoever, but the principles discussed in the article are still relevant:
What many new traders do not realize is that the majority of all markets’ movements on a day-to-day basis depend on investors’ risk sentiment, or how optimistic or pessimistic traders feel about the global economy that day. If investors feel optimistic, they tend to put on “risky” bets across all asset classes, whereas if they are pessimistic, they will flock to “safer” assets. A quick way to evaluate risk sentiment is to look at your local stock market index; in general, if the world’s stock markets are up, we are looking at a “risk on” day.
The currency market is not immune to the manic-depressive personality of traders. On days when risk sentiment is bullish, we tend to see currency traders buy up higher-yielding currencies, such as the Australian dollar, New Zealand dollar, Euro, and Canadian dollar. Conversely, on “risk off” days, traders move their money to “safe haven,” low-yielding currencies such as the U.S. dollar, Japanese yen or Swiss Franc.
The implications of these risk correlations are profound. Most days, fluctuations in the New Zealand dollar are driven by traders’ feelings toward the global economy, which lately depends heavily on developments in the Eurozone, rather than any changes in New Zealand’s economic outlook.
In the current market environment, it is no long enough to monitor whether different trades entail excessive positioning in one currency; traders must also watch whether the sum of all open positions is overly skewed toward a given risk sentiment. For example, a trader with long positions in AUD/CHF and NZD/JPY, as well as a short in USD/CAD, would be exposed to a sharp reversal in risk sentiment, despite not having duplicate positions in any single currency. See the tight correlation between the AUD/CHF and NZD/JPY in the 1hr chart below:
* Note that there is no guarantee that this correlation will persist, and other factors beyond investor risk sentiment could cause the correlation to weaken in the future
A trader with the above 3 trades, even if he limited his risk to 3% of total account equity on each position, could unknowingly be risking nearly 10% of his account in the event of a large risk reversal, such as we saw on Wednesday. A trader without stops or a proper risk management plan could be hopelessly overexposed and may quickly experience a debilitating loss if all 3 positions moved against him simultaneously.
In conclusion, you may not be as diversified as you think. Successful traders always keep an eye on their total exposure to investor risk sentiment, as well as individual currencies. The forex market is an extremely volatile and competitive market, and avoiding large, preventable losses is the best way to stay in the game.
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