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If You Haven't Yet, Evaluate and Reduce Your Risk

If You Haven't Yet, Evaluate and Reduce Your Risk

John Kicklighter, Chief Strategist

Talking Points:

  • Favorite 'risk' assets were expensive long before our 2018's bout of uncertainty kicked in
  • Now, risks to stability have grown both in number and intensity with an 'accident' or intentional collapse inevitable
  • Evaluate your risk and take action: diversify, seek out hedges or simply reduce exposure

See how retail traders are positioning in USDJPY, other FX crosses, indices, gold and oil intraday using the DailyFX speculative positioning data on the DailyFX sentiment page.

The Threats to Stability and Risk Trends are at Nose-Bleed Levels

Frankly, at this point, the current level of stability in the global financial markets is nothing short of remarkable. After nearly a decade of general advance for investor sentiment and speculative markets, we have come upon a period of unmistakable instability. The foundation for systemic risk has been building in the financial backdrop for some time. A dependence on complacency and leverage has supplanted tangible fundamental motivation and reasonable rates of return. With benchmarks for speculative exposure such as US equity indices pushing record highs, are have been left with a distinct imbalance between the risks we adopt with gaining fresh exposure to a market versus the anemic expectations of returns. Yet, we have been able to overlook this unfavorable ratio as momentum behind capital gains has compensated for a lack of genuine income returns (yields, dividends, earnings). These are the conditions that shape the environment, but we still await the catalysts that draw clear and unambiguous attention to the fundamental imbalance. As it happens, we happen to have an abundance of capable themes and events to trigger such recognition. It is advisable to be cautious in this environment.

If You Haven't Yet, Evaluate and Reduce Your Risk

Diversification and Safe Havens

Following years of gradual build up in risk exposure, it is reasonable to start reducing absolute risk so as to better conform to the risk-reward ideals that the financial system currently presents. While it may take some time yet before we see the eventual, systemic deleveraging of excess exposure; the 'potential' risk relative to the tepid returns overwhelm the sense of appeal for a slim 'probability' that still favors the pursuit of outright return. With that said, what is the best way to significantly adjust our exposure to the market in order to avoid risk? One of the most overused but practical methods for reducing risk is diversification. Spreading out exposure reduces the concentrated risk in any specific asset. However, it does come with its limitations. And we are seeing those shortfalls show through in current markets. After years of speculative build up, there has been an over-extension in risk exposure across the board. If we were to see a collapse in sentiment, the sharp rise in correlation would pull all of these expensive markets down in tandem. In a similar vein, we could just incorporate more 'safe haven' exposure into our net holdings, but that introduces a more recent risk: the ambiguity of what still represents an absolute safe haven. The Dollar, for example, is not as responsive to fear as it has been in the past.

If You Haven't Yet, Evaluate and Reduce Your Risk

Hedges are Remarkably Cheap

When I started out trading, it was through options. This has imbued me with a steadfast appreciation of the critical elements that go into pricing such derivatives. Time frame, relative strike price and implied interest rate are all unique values that fall into pricing; but it is implied volatility that more readily earns our attention. Whether we are referring to anticipated activity levels for equities, FX, yields, commodities or other markets; the outcome is the same: expectations are set exceptionally low. It is exceptionally unrealistic to project a short-to-medium term outlook for markets to remain so passive. That should put us on alert as it suggests there is a lack of preparedness in the broader market, but it can also present an opportunity - whether to curb risk or ready for speculative positioning. If implied (anticipated) volatility is so low in the face of probable sparks, it means the hedges are cheap. In fact, the VIX volatility shows exactly this in a historical perspective. Yet we can dig even deeper to expose that open interest in VIX futures has softened remarkably while net speculative position remains inexplicably with a hearty net short bearing. Rather than fully divesting out of 'long risk' assets, an affordable hedge may prove more cost effective is properly managed.

If You Haven't Yet, Evaluate and Reduce Your Risk

When In Doubt, Reduce Exposure and Time Frame or Sit it Out

Diversification can be difficult as market flux renders historically safe assets as newly at risk. Hedging similarly comes with its own pitfalls as improper speculative offset along with a lack proper rebalancing as markets move can lead many traders down an unsustainable path. If these elements are too difficult to reasonably account for, there is yet another time-tested means for deflating risk: reduce exposure. This can of course be done by just taking an increasingly significant portion of assets out of the market. Yet, the options can be less definitive and perhaps more effective if we lower exposure by other means. In addition to decreasing net exposure and leverage, we can shorten the anticipated time frame of our trades or set targets significantly closer. And, when we are simply not confident at all in the direction and activity level ofthe market, we can always exit the market fully until we are more confident of the markets motivations and bearings. We discuss the need and means for reducing risks in markets in this weekend Quick Take video.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.