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The Three States Of The Financial Market: It Is All About Risk

Written by A Forex View From Afar on Wednesday, June 17, 2009

In its natural stance, the financial market has three major attitudes towards risk, which models its behavior and actions throughout each of the global trading session. The three are; risk aversion, risk tolerance and risk-neutral.

Risk-aversion is characterized by investors selling assets considered risky, and swapping them for the safety of the bond market, mainly U.S. Treasuries. Risk-aversion can be seen relatively easy; commodities decline as investors consider that consumption will slow, while the S&P futures also head lower. In the currency market, risk-aversion strengthens the dollar, as investor sell foreign denominated assets to buy U.S. Treasuries. In this period, higher yielding currencies are the one being sold the most.

The risk-tolerance phase is seen when Treasuries are sold as investors are looking for higher yields. In periods of relative calm and positive macroeconomic reports, traders abandon the safety of the bond market and invest their capital in stocks, commodities and foreign currencies, thus in this period the dollar is sold. Usually, bull markets are characterized by risk-tolerance phases and in this period S&P futures head higher, together with the euro and the rest of the pack.

In most cases, risk-neutrality happens when the financial market moves side-ways, unable to push anywhere decisively. This period is characterized by a redistribution period, as investors shift their assets between the various financial instruments to prepare for the next leg (risk aversion or tolerance). The main difference being that the shifts are not only session-by-session, they literally happen hour-by-hour. Sentiment is seen to change from one to the other, empowered by the relentless flow of automated trades that trigger as a contingency play, as each individual market accepts risk neutrality.

The sideways moving market tends to be the more volatile as the channels are traded, and fair value sought at each regional market open. June has been a risk neutral month; the equity markets are unable to attract enough volume to make a stance on risk, and therefore the currency markets spin their wheels each day as dollar values are fought over.

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Fundies and Trading
There is a constant question from some traders as to why anybody would ever need to consider the ‘F’ word when trading. Fundamentals: what is so damaging at looking at both Technical charts and having a Fundamental filter to gauge how many Lots to put on? Why is it that accepting that Technicals give us price points to trade, but Fundamentals determine the direction that we travel is so difficult for some traders to accept? Without a Fundamental Filter very few pure Technical traders would have seen this Dollar move coming today.

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