The only certainty we know of in the financial markets is that there is plenty of uncertainty, and that many factors can change the level of volatility in markets. One of the most common causes of volatility is headline risk. This is when a piece of news is released without prior notice, producing an instant knee-jerk reaction in the form of a volatility spike, usually induced by computer algorithms. Changes in the geopolitical or economic landscape can also quickly change how traders perceive risk in any given market. Lately, around the world we’ve experienced a spate of these triggers causing lots of changes in the direction of the markets.
Essentially, money will move where it is best treated (in terms of risk versus reward). This means that in times of increased volatility, the trillions of dollars being traded on a daily basis begin to be reallocated to different types of assets as the levels of risk change. So, when assets that produce the best returns – which by definition also carry the most risk- are doing well, traders and investors will stay with these and sell those assets that carry less risk but garner much lower returns, and vice versa. These two buckets of assets are referred to in the financial business as risk-on and risk-off assets.
What Are Risk-on and Risk-off Assets?
Risk-on assets are high growth, economically sensitive and emerging market stocks. In addition, all their related products, such as ETFs, options and commodities can also go into the risk-on basket. High yielding corporate bonds and the carry trade are also used to maximize returns in a bullish environment using a strategy that involves borrowing (shorting) lower rate currencies to buy high yielding currencies. The resulting spread between the interest rate differential is where profits are derived.
In the futures markets the risk-on contracts are all of the E-mini equity products such as the S&P, Nasdaq 100, Dow and Russell 2000. Crude oil can also be included. Conversely, gold, bonds and the Japanese Yen are the most significant risk-off contracts.
A futures trader who understands these inverse correlations can build a strong edge, if he or she knows what to look for. The markets are very good at throwing off clues. The challenge, however, is that too many traders tend to hold a strong bias or opinion about where the markets should or could go. Instead, what a trader should practice is observing what different markets are suggesting about what institutional investors are doing (the smart money). This can give a trader a high probability situation that can be seized upon when the markets are moving. In recent weeks, these inverse correlations have been quite stark.
Trade Tariffs and Stock Market Volatility
A good example of this dynamic happened on Tuesday, August 13, 2019 as news of an easing in Chinese tariffs hit tape. As we can see from the chart below, the E-mini S&P surged immediately after the news was released.
The perception was that the tariff threat that was dampening the prospects for earnings and growth in the economy would have been ameliorated by the postponing of those tariffs that were due to be imposed on September 1. This news set in motion a buying frenzy by computers competing to buy, and sellers moving their offer prices (sell orders) to much higher.
By contrast, those that were positioned in a defensive posture (in risk-off assets) going into that day quickly unwound those positions. Comparing the E-mini S&P surge showing above with the charts below shows the glaring inverse relationship as gold and the Yen dropped precipitously and, to a lesser extent, so did the 30 year T-bond contract.
As you can see, having a thorough understanding of how the markets are traded and how they are intertwined could help a trader make better decisions and craft a better set of rules to improve their results.
Until next time, I hope everyone has a great week.