Understanding Risk Sentiment
In financial markets, risk sentiment is a term used to describe a trader’s behavior. In other words, risk sentiment is how much risk traders are willing to take.
Take risk sentiment as the mood of the overall market. If the market is bullish, traders would prefer to go long.
When you have an open position, you are always at risk, as there is a chance that your trade will result in a loss. This is how markets play on the sentiment of every trader. They exploit two main drivers of human emotions; fear and greed. Are the traders taking the risk, or are they back footing?
These questions move the market, hence describing the overall risk sentiment.
When talking about risk sentiment, two terms are essential; risk on and off.
It’s just like a switch, but a switch of the overall market mood.
Risk-on is when the market is in a favorable condition. All the factors are positive, and the volatility is low. In this scenario, traders are confident in their buying, and they are not seeking safe-haven currencies.
Risk-off is when the overall market condition is going down, and there is a high level of volatility. Anything from global crises like Covid-19 or an economic recession can disrupt the market, and the risk sentiment goes to risk-off.
In times like these, traders prefer to seek safe-haven assets like gold or Swiss Francs.
Importance of risk sentiment
Understanding risk sentiment is part and parcel of trading. By knowing risk-on and risk-off, traders can better interpret the market.
A keynote to add here is that the market can be at risk on and risk-off for days, months, or even years. So, traders need to adjust accordingly.
For instance, the oil market is in a risk-off situation because of the ongoing pandemic. If the trader did his analysis back when the pandemic was starting, he would have exited his/her buy trades.
How to measure risk sentiment?
At this point, you’ll be saying, “Oh yeah! I know about risk on and off, but which currencies are more sensitive to risk sentiment?”
Let’s find out.
Safe-haven currencies are mostly subtle to risk sentiment. When the market goes from risk on to risk-off situation, safe-haven currencies provide shelter.
There are three main currencies to look for in the forex market for measuring risk sentiment.
The USD has a negative correlation with the risk sentiment. The stronger USD means the market is in risk-off mode. Many traders prefer to buy USD pairs in times of uncertainty, causing the USD to rise.
Many traders buy Swiss Francs in times of market uncertainty. This is because the CHF acts as a safe-haven currency.
In times of market turmoil, traders combine CHF with high-yielding currencies like USD. The stronger CHF is a sign of risk-off sentiment.
Japanese Yen is considered as a safe haven by traders and investors. Most of the liquidity flows to JPY when a natural disaster or a bad news appears in the scenario. Similarly, when risk appetite is high, JPY is heavily sold.
Knowing the risk on and off condition tells us about the overall market sentiment. These market situations move back and forth, so traders should adjust themselves accordingly.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.