Posted on: 30 Oct, 2018
In this tutorial, I will explore the different risk profiles that can be at play in the forex market. If you trade risk-sensitive currencies such as the Japanese yen or the Swiss franc, what I am about to explain should be at the very top of your list. You really have to see it as your own little bible to trade JPY or CHF.
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While moves in the currency market can be influenced by a web of complex factors, ultimately though, these myriads of elements, in its simplest form, boil down to understanding two key drivers:
1. The anticipation of higher or lower interest rates by Central Banks, which creates a divergence in monetary policies as in the current case of the Federal Reserve and the European Central Bank as an example.
2. The other element to complete the equation has to do with risk sentiment. In other words, are we trading an environment conducive for a reshuffling of portfolio strategies into riskier-currencies? Or does fear, uncertainty, and doubt rule the behavior of market participants with safe havens to benefit?
Failure to deconstruct the proper trading environment can lead to unnecessary loses just because you didn’t have the knowledge to distill and interpret the right market conditions at play. The fact that financial markets have become so intertwined and dynamic makes it essential to stay constantly in tune with market conditions and adapt to new environments.
The root cause that leads to many aspiring traders to perpetually be jumping from one strategy to another in a constant vicious cycle comes, at its core, from the inability of the system to adapt to the market context. On a rainy day, if you don’t use an umbrella, you’ll get wet, right? In the forex market, one can apply this metaphor by playing long risky currencies (AUD, NZD, CAD) while risk-averse conditions (rainy day) are present. You’ll probably get wet.
This guide focuses on the deconstruction of these different types of risk sentiment scenarios or weather conditions as the analogy goes. It includes a prop model that will assist you to constantly gauge the context that you are trading so that you can significantly reduce the downside risks (wet days) while embracing the days the market offers sunny conditions (profits).
Firstly, to get to grips with the proper interpretation of risk sentiment, one has to make the distinction between the currencies linked to ‘risk on’ or risk appetite and the ones that we must associate to ‘risk off’ or risk aversion.
Out of the top eight currencies in the forex market, we can essentially break them down into two main groups as shown below:
We can then further distill these currencies into sub-groups. AUD, NZD, CAD are referred to as commodity currencies, while the EUR, GBP, CHF form part of the European bloc. This distinction is important, especially as the lay of the forex land stands in 2018, as it will help us understand market dynamics.
It’s now time to bring to the forefront and incorporate four financial instruments that should always be at the epicenter as the absolute heavyweights to illuminate our path and act as barometers of risk. These include the S&P 500, the US 30-yr bond yield, the DXY index, and to a lesser extent Gold*. The ebbs and flows in these asset classes, when properly interpreted, will open floodgates to a tsunami of fresh knowledge and provide the tools you need to determine what type of risk profile is dominant.
*During 2018, Gold has become a function of USD performance in the majority of cases. As it stands, it has temporarily outlived the same degree of usefulness it used to have to monitor risk.
Since I am aware that it can be quite daunting to be monitoring the gyrations of up to four different instruments, here is a tip for you. I will provide you with a formula that has become the most intuitive way and my all-time favorite tool to capture the ever-evolving intraday risk sentiment.
On Tradingview, you must replicate the following calculation:
As of Sept 18th, the calculation reads ES1!/2892+US30Y/3.15-DXY/94.42. Note, to keep the accuracy of the index, you must update the values of the denominator at the start of each trading day.
This equation will result in what I refer to as an intraday risk-weighted index (RWI) with an initial score of 1 and a constant fluctuation in value. Note, I use two versions, this one that is best suited for intraday trading, while the second version is a more macro calculation with up to 9 instruments to monitor, accounting for emerging markets, junk bonds in the US, etc. I will probably dedicate an entire tutorial to explain the large version.
What I’ve done is to put together a cheat sheet so that I can make it more visually intuitive and eye candy for you. Find the table below:
You can also watch a video I’ve put together:
It’s important to note that in 4 out of the 6 risk scenarios, with the exception of an environment driven by broad-based USD weakness or strength, the RWI will be guiding us with accuracy as a barometer for risk. The way you want to read the RWI is based on its evolving structure and what type of scenario has caused the break into new highs or lows. Then it’s just a matter of matching up that scenario with the most advantageous direction to trade as long as you can find a price that is appealing enough for you to engage as a trader.
The ones that I call extreme ‘risk on’ or ‘risk off’ are the most straightforward, and it involves a surge or decline in both the S&P500 and the US 30-yr bond yield. When these moves occur, independently of the DXY performance, it actually fulfills one of the general rules about risk sentiment, that is, a move in the same direction by the S&P500 and the US30-yr bond yield, either up or down, will result in either ‘risk on’ or ‘risk off’ conditions.
The second and fourth scenario in the table above is what I refer to as ‘solid’ ‘risk on’ or ‘risk off’. In this type of directional move, the S&P500 detaches from the overall positive or negative risk but the fact that both the USD and the US 30-yr bond (not the yield) move in the same direction, communicates that the market is still very much on its toes ready for any risk eventuality.
As I explain in the table, only when a USD-led move develops — 5th and 6th scenarios — , we must resort to the cues provided by the S&P 500*. However, this scenario tends to be tricky to trade at times, as fundamental-led factors may then play a role for a currency to have a temporary disconnect.
*Note, if you trade through Europe, you still can keep the S&P500, but I recommend replacing it with the DAX30 as the leading indicator.
As an example: If we have USD weakness across the board yet the S&P 500 rises, it argues for friendly risk conditions, which may suggest the prospects to buy let’s say GBP/JPY. However, we may find ourselves in a situation where negative fundamental news is having an impact in the sterling, keeping the pair pressured. Therefore, aside from all the scenarios and its respective descriptions, one must always factor in individual currency criteria at play. Knowing your currencies’ fundamentals is vitally important.
Remember, the differentiation of risk scenarios will yield the most benefits when trading the yen or Swiss franc crosses as the currencies most linked to risk. My personal preference is the Japanese yen, as the Swiss franc can at times behave a bit more erratically, playing catch up to the Euro. In my experience, the RWI tends to be best suited if you stick to trading pairs such as the AUD/JPY, USD/JPY, CAD/JPY, NZD/JPY, EUR/JPY, GBPJPY.
At the end of the day, the crux of the matter is to find exploitable divergences that occur between the structure of the RWI and the pricing of the pair.
Remember, if you want to find out how I personally strategize my approach to trading divergences in correlated instruments, you can refer to my guide on trading correlated assets.
Let’s not leave any stone unturned. Allow me to show the strong correlation the RWI has against yen crosses. In the majority of times, the correlation is strikingly high as the chart below illustrates (1h chart on a 30-period).
The times when the correlation breaks down, more often than not, has to do with a USD-driven scenario. When this happens, it tends to debunk the usefulness of the RWI direction and one must look for clues via the S&P500.
Next, we will take a glimpse at a few examples as an exercise to demonstrate the edge one can gain if combining the RWI and a risk-sensitive pair.
Below you can find the RWI, its respective instruments, and in a thick blue line the AUD/JPY as a proxy for risk. Upon closer inspection, you will notice the run-up was on an extreme ‘risk on’ environment. Meanwhile, the topping formation that led to the breakout of the RWI structure came as the S&P500 and the US30yr bond yield both got hammered while the DXY stayed under pressure, which would fit into our 6th scenario of USD weakness. Therefore, the moment the S&P500 cracked support, it was then a matter of finding attractive levels to engage in AUDJPY shorts (white arrows).
In the following example, the RWI broke its bullish structure by creating lower lows as the horizontal orange line is penetrated. Here is the key: The move in the RWI occurs amid USD strength (higher DXY & US 30-yr bond yield), therefore the SP500 will be our ‘lead’. Notice how the break of the structure in the RWI is a function of a sudden drop in the SP500? That’s the trigger to sell the AUD/JPY at the level one may consider being attractive enough.
I personally tend to wait for retests of highs/lows but it doesn’t have to be the case. One can use the RWI to serve you as confirmation to engage in trend trading JPY crosses if you find the index moving in tandem with the pair.
By now, you’ve probably developed a fairly solid grasp about how the RWI can be an essential tool to incorporate as part of your trading arsenal. Now it’s just a matter of constant practice to perfect your craft and up your game to a whole new level. Don’t forget, nobody likes getting wet on rainy days after all!
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