Risk aversion trading

For several months, it seemed financial markets had moved beyond risk aversion and returned to trading fundamentals and technicals. However, with that most volatile month of September looming and markets becoming jittery with the forecasted U.S. economic slowdown actually beginning, it’s worth reviewing the forex trading rules for a risk averse market.

1. Watch the headlines. Risk aversion isn’t a steady force. It waxes and wanes in direct relationship to the economic situation du jour, with the forex trading market steadying when news is reasonable or quiet, and becoming jittery when headlines scream. Forex traders must monitor the “volume” of the headlines to follow the market’s risk averse status.

Different headlines will affect different currencies. For example:
•    Should commodity prices fall, that will tend to depreciate the related commodity dollars of Australia, Canada, and New Zealand.
•    If European growth slows, that will inhibit the mainland Euro and Swiss franc, while allowing the pound sterling to gain against them but suffer against non-European currencies.
•    Generalised anxiety will tend to support the safe-haven U.S. dollar, Swiss franc, and Japanese yen, while punishing the currencies considered riskier, including the Australian and New Zealand dollars.
•    For traders with access to the gold cross (XAU/USD), it has a mind of its own re risk aversion but the long-term trend remains bullish.

2. Understand the various roles filled by USD. The U.S. dollar is more than the domestic currency of the United States. It’s also:
•    The de facto inverse to the commodity currencies, e.g., when AUD rises, USD tends to fall, and vice versa.
•    A funding currency for the carry trade when markets are calm, with traders borrowing USD at its currently low interest rate and investing in nations with higher rates, to earn the differential “spread” between the two.
•    Historically the premier safe-haven currency, the one many traders flock to when markets become jittery.

It’s important for forex traders to understand which role USD fulfills at any given time, as these roles change without notice and its movements within a jittery market will not always be logical. The depths of the global financial crisis saw the remarkable situation where USD strengthened dramatically on the announcement of deteriorating U.S. economic data.

3. Trade correlated pairs with caution. Within forex trading, sometimes one fundamental announcement or headline will influence different currency pairs in similar ways. For example, rising commodities prices tend to strengthen AUD/USD and NZD/USD while weakening USD/CAD. This tendency to move together is called correlation, and the information is widely available online.

However, correlation factors change without warning and all the time. While trading correlated currency pairs will always be a good method of maximising profits, when markets are jittery it’s important to monitor the tables and the trades to prevent a position eroding.