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Speculative Exaggeration Has Led to Risk, Brexit and Volatility Reach

Speculative Exaggeration Has Led to Risk, Brexit and Volatility Reach

John Kicklighter, Contributor

Talking Points:

  • Speculation is an indelible element in all markets, but its influence can fluctuate
  • In the Brexit vote, speculation overrode logical assessment of risk-reward and led to a dramatic Pound tumble
  • US equity benchmarks and favored volatility products (like the VIX) show similar skew in the risk-reward balance

See how retail traders are positioning in the majors using the SSI readings on DailyFX's sentiment page. What are the Traits of Successful Traders?

Investment and markets are not always rational. Speculation is a constant presence in the market and sometimes it is a dominant force. When 'animal spirits' outpace a logical valuation of the market's opportunity and risk, conditions grow unstable. That doesn't mean that a rebalancing is imminent, but it does skew potential and distort the appreciation of risk. The motivations for this skew can vary; but two of the most prominent sources of late are an insatiable appetite for exceptional return and a complacency born of central bank influence.

One of the most dramatic examples of the fog that speculative distortion can create over the past few months was the Pound's bearings before and after the Brexit. A logical evaluation of the event would suggest that a vote to 'leave' would have been far more severe than the decision to 'remain'. Yet, despite that asymmetry and the remarkably close polling between both camps heading into the June 23rd vote, traders bid GBP/USD higher and did little to protect against the alternative outcome - hence the severity of the pair's plunge.

The Brexit vote is an example where an imbalance between speculative positioning and logical value could be corrected abruptly with a singular event. There are other areas where speculation is not following out so defined a course with a specific time or event in mind that can render the reach justified or not. The lofty heights of the S&P 500 is perhaps one of the biggest - and most ambiguous - speculative fevers in the market as it draws from deep wells of distortion in the form of central bank influence. Along similar fundamental lines, volatility products have arguably moved deep into the speculative spectrum of the investment scale. Record short appetite at already exceptional lows represents an extremely low return potential against very high risk while the market shows little concern of the consequences in positioning. We discuss what happens when markets lean to heavily on speculation in today's Strategy Video.

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