Risk Sentiment

Risk sentiment refers to the behavior and emotions of participants in the financial markets, including traders and investors. The decisions traders make about buying or selling involve weighing their potential losses against their expected gains. Essentially, risk sentiment reflects the willingness of traders and investors to embrace risk, which involves understanding both individual risk tolerance and the overall market's attitude toward risk within a specific timeframe. You can think of risk sentiment as the prevailing mood of the financial market.

Risk is defined as the exposure to the possibility of loss or injury. When a trader holds an open position in the market, they are inherently taking on risk, as there is a chance that their trade could result in a loss. The financial markets are influenced by the risk sentiment of traders, who are often swayed by two primary emotions: fear and greed. Given that much of the activity in financial markets is driven by short-term speculation, understanding risk sentiment is crucial for traders.

Risk sentiment can indicate whether traders are "seeking risk" or "seeking safety." The terms "risk on" and "risk off" are frequently used in financial media. A "risk on" environment occurs when the market is willing to take on risk, typically characterized by an optimistic economic outlook, supportive economic data, and low to normal price volatility. In such a mood, traders are more inclined to engage in riskier trades, seeking higher returns by investing in "risky assets" while selling "safe haven" assets. This often leads to a rotation of capital into riskier investments, where the potential for higher returns comes with an increased risk of loss.

Risky assets can include stocks, commodities, precious metals, and higher-yielding currencies, ranging from major currencies like the Australian dollar (AUD) to emerging currencies like the Brazilian real (BRL).

Conversely, a "risk off" environment arises when the market is focused on safety. This typically occurs during periods of poor or deteriorating economic outlooks, disappointing economic data, and high price volatility. Unexpected negative events, such as financial crises, health emergencies, geopolitical tensions, political scandals, election outcomes, and natural disasters, can shift market sentiment to a "risk off" stance. In this mood, traders become more risk-averse, often opting to sell risky assets and buy safe haven assets. During turbulent market conditions, investors seek out safe havens that are less affected by worsening economic conditions, rotating their capital into these lower-risk assets.

Safe haven assets are viewed as the best means of preserving capital during times of risk aversion or panic. The ultimate safe haven asset is cash, but other examples include U.S. government bonds, the Japanese yen (JPY), the Swiss franc (CHF), the U.S. dollar (USD), and gold (XAU). For stock traders, shares in companies within the healthcare, utilities, and consumer staples sectors are also considered safe haven or "defensive" assets, as these companies provide essential products regardless of economic conditions.

Understanding risk sentiment is vital for capital preservation and effective risk and emotion management. The daily or weekly fluctuations in markets often reflect changes in risk sentiment. By being aware of this, traders can better comprehend market behavior, remain calm, interpret news, and analyze economic data with greater clarity. It's important to note that shifts in risk sentiment can occur gradually or suddenly, with markets potentially remaining in "risk on" mode for extended periods before quickly transitioning to "risk off" mode.

When assessing market news and data, consider whether it is positive or negative for risk sentiment. The impact of news will dictate the extent of any shifts in sentiment. For instance, a minor disappointing economic data release in an overall improving environment may have little effect on current risk sentiment, leading markets to continue buying risky assets. Conversely, a significant negative result in major economic data against a deteriorating economic backdrop can greatly influence risk sentiment, prompting a shift from "risk on" to "risk off," resulting in a sell-off of risky assets and a rally in safe haven assets.

When markets are in "risk off" mode, bearish sentiment prevails, leading to subdued price action and potentially rapid declines in asset prices.

To effectively utilize risk sentiment in trading, it's essential to know how to gauge it. Here are four indicators to monitor for determining whether the environment is "risk on" or "risk off":

U.S. Stock Indexes
The U.S. stock market indexes serve as clear real-time indicators. The three most closely watched indexes are the S&P 500, Dow Jones Industrial Average (DJIA), and NASDAQ Composite. These indexes not only reflect the U.S. economy but also the global economy. Financial media outlets like CNBC and Bloomberg frequently report on the performance of these indexes. If the stock indexes are rising, it indicates a "risk on" sentiment; if they are falling, it suggests a "risk off" sentiment.

VIX
The VIX Index, also known as the "Fear Gauge" or "Fear Index," helps measure the level of risk in the stock market. This volatility index assesses the likelihood of sudden price movements and is widely used by traders to gauge market anxiety. The VIX measures market expectations of future volatility in the S&P 500 index. A higher VIX indicates greater fear in the market, while a lower VIX suggests calmness. A VIX value above 30 indicates high volatility, while below 20 indicates a more stable market.

U.S. Government Bond Yields
U.S. Treasuries, issued by the U.S. Treasury Department, are considered nearly risk-free investments. The yields on these bonds are closely monitored by financial media. Rising yields suggest that the market is selling U.S. government debt, indicating optimism and a shift to "risk on." Conversely, falling yields indicate that the market is buying U.S. Treasuries, reflecting fear and a shift to "risk off."

Safe Haven Currencies
Currencies are highly sensitive to risk sentiment, with safe haven currencies reacting quickly to shifts. The forex market operates 24/7, allowing for continuous monitoring of risk sentiment. A strong U.S. dollar (USD) against higher-yielding currencies indicates "risk off" sentiment, as investors seek the safety of the dollar. Similarly, strength in the Swiss franc (CHF) and Japanese yen (JPY) against higher-yielding currencies suggests market turmoil and a flight to safety.

It's important to remember that no asset is completely risk-free. The notion of a "permanently safe" asset is misleading, as true "risk off" conditions do not exist. Even cash carries the risk of inflation eroding purchasing power. The terms "risk on" and "risk off" simply describe the prevailing mood of market participants, influencing their buying and selling decisions, which in turn causes significant price movements in various assets.

To assist in measuring risk sentiment, you can also utilize our Risk-On / Risk-Off Meter.