Risk On Risk Off Trading Strategy

Risk On Risk Off Trading Strategy (RORO): Backtest, Performance, and Examples Analysis

One often-mentioned expression in the financial markets is “risk on risk off”. What is it, and can you use it to develop a profitable risk on risk off trading strategy?

A risk on risk off trading (RORO) strategy takes advantage of the shifting market sentiment that influences the performance of different asset classes. When it is “risk on” typical risky asset classes tend to go up while more defensive asset classes less so (even go down).

Let’s look more closely at the risk on risk off concept and how you can develop such a trading or investment strategy.

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What is a risk on risk off strategy?

A Risk On Risk Off (RORO) strategy is a trading and investment approach that seeks to take advantage of the shifts in investor risk appetite and sentiment across different asset classes.

Put short, the strategy involves buying higher-risk assets during “risk-on” periods and selling them during “risk-off” periods, while simultaneously buying safer assets during risk-off periods and selling them during risk-on periods.

In the media, this strategy is frequently mentioned, especially when crypto and Bitcoin takes off.

Investors tend to favor higher-yielding, higher-risk assets such as stocks, high-yield bonds, crypto, emerging market currencies, and commodities in a risk-on environment. In contrast, investors tend to favor safe-haven assets such as US Treasuries, gold, the Swiss Franc, and the Japanese yen during a risk-off period (this is just examples and no investment advice).

The RORO strategy seeks to profit from these shifts in investor sentiment by identifying and trading assets that are likely to benefit from a risk-on or risk-off environment. There are many ways we can make a risk on risk off strategy, and further below we show several different methods and strategies.

Which assets are typical risk on assets? What does it mean?

Risk-on assets are typically those that have a higher potential for return but that also includes a higher risk, of course. Such assets tend to perform well during periods of positive market sentiment and economic growth, and their prices are often positively correlated with economic growth and inflation.

On a personal note, we suspect a lot of this is due to FOMO (Fear Of Missing Out – what is it?). This is a very powerful force and brings out the worst in many traders and investors.

Let’s look at some typical risk on assets:

  1. Stocks: Stocks represent ownership in a company or business. Stocks tend to perform well during periods of economic growth and optimism, as companies generate higher revenues and profits. When the sentiment is positive, all pullbacks are a great buying opportunity.
  2. High-yield bonds: High-yield bonds, also known as “junk bonds,” are issued by companies with lower credit ratings and carry a higher risk of default. However, they also offer a higher potential return to compensate for the increased risk. Junk bond trading strategies tend to behave very much like stocks.
  3. Commodities: Commodities such as oil, copper, and gold tend to perform well during periods of economic growth and inflation, as demand for raw materials increases. However, this is not exactly proven by research. For example, we investigated the relationship with a copper vs. stocks trading strategy.
  4. Emerging market currencies: Currencies of emerging market economies, such as Brazil, Russia, India, and China (BRICs), are often considered risk-on currencies due to their higher potential for return but also higher volatility. Perhaps even more so, are more periphery markets like Argentina, Mexico, African countries, etc.
  5. A recent addition to risk on risk off assets, are is crypto. Crypto is new and it might be premature to conclude.

What is risk on risk off day?

This refers to a day where typical risk on assets go up and risk off assets go down. In other words, money flows into less risky assets. When it’s risk off, money moves the other way.

Is Bitcoin risk on risk off?

Bitcoin is a typical “risk-on” asset, at least it’s presumed to be, meaning that it tends to perform well during periods of positive market sentiment and risk appetite. This is because Bitcoin is often viewed as a speculative asset and tends to attract investors seeking higher returns.

Additionally, we might argue crypto investors are much less experienced than stock and bond traders, especially the latter. We believe bond traders are the best macro traders – much more so than stock traders, for example.

As an example of Bitcoin and risk on risk off hypothesis, let’s look at the performance of Bitcoin when S&P 500 is trading above its 15-day moving average. When S&P 500 is trading below the 15-day simple moving average, we are in cash:

Risk on risk off example

The returns are higher than buy and hold: 71.15% vs 58.42 annual returns. If we flip the trading rules the equity curve looks rather poor.

Risk on risk off bitcoin

Let’s make a second backtest were we employ the same trading rules as above but instead of stocks use bonds as a proxy for “risk on”. Bitcoin performs even better when we use Bonds as an indicator:

Risk on risk of trading strategy

The equity curve is sloping steadily upward and has annual returns of 73%.

Thus, all the returns in Bitcoin have come when the stock market and the bond market has been strong.

Why is that?

That is because during market optimism and positive risk sentiment, investors are more likely to invest in higher-risk assets, including cryptocurrencies like Bitcoin.

Conversely, during periods of market pessimism and negative risk sentiment, investors are more likely to flock to safer assets such as US Treasuries, and other safe-haven assets.

In other words, we can argue our theory of Bitcoin as an risk on asset is confirmed.

What is a risk on risk off indicator?

A Risk On Risk Off (RORO) indicator is a technical tool used to measure the broad sentiment of investors and traders towards risk in the financial markets. RORO indicators help traders and investors identify whether market participants generally are in “risk-on” or “risk-off” mode.

One way to do this is to make an indicator that tracks the performance of certain assets. For example, you might track 10 different assets and determine if they are in a positive or negative trend, normally by using strict quantifiable trading rules. If the majority of them is in “risk on” mode, you might go long the asset you are evaluating. If not, you might stay out.

Bloomberg has such an indicator in their terminals with its own methodology and calculation. It measures the relative strength of different asset classes and assigns a score ranging from -1 to +1, with positive scores indicating a risk-on sentiment and negative scores indicating a risk-off sentiment.

Additionally, two other indexes exist: the Dow Jones Credit Suisse Core RORO Index and the Goldman Sachs RORO Indicator.

What is risk on risk off currencies?

Risk on risk off (RORO) currencies are those that tend to be influenced by the broader market sentiment and the appetite for risk among investors. These currencies are often associated with countries with large current account surpluses or commodity exporters, which means they tend to benefit from a risk-on sentiment in the market.

Investors tend to favor higher-yielding, higher-risk assets, including RORO currencies, when the risk appetite is on. These currencies tend to appreciate as investors seek higher returns, which can increase demand for these currencies.

Conversely, during a risk-off period, investors tend to flock to safer assets, which can decrease demand for RORO currencies.

Below we list a few risk on currencies:

  1. Australian dollar (AUD): Australia is a major exporter of commodities such as iron ore and coal, and its currency is thus often seen as a proxy for global commodity prices. The AUD tends to appreciate during periods of strong global economic growth and positive market sentiment.
  2. Canadian dollar (CAD): Canada is another major commodity exporter, with a large share of its economy dependent on the oil and gas industry. The CAD tends to rise in value during positive market sentiment and higher oil prices.
  3. New Zealand dollar (NZD): Like Australia, New Zealand is a major exporter of commodities such as dairy products, and its currency tends to rise in value during periods of positive market sentiment and higher commodity prices.
  4. Emerging market currencies: Currencies of emerging market countries such as Brazil, Russia, India, and China (the so-called “BRIC” countries).

Opposite, typical risk off currencies are the Swiss franc and the Japanese yen, and also the US dollar. When a crisis hits us, the USD tend to appreciate.

Is gold risk on risk off?

Gold is often considered a “risk-off” asset, meaning it tends to perform well during market pessimism and negative risk sentiment. During these periods, as mentioned, investors often seek out safe-haven assets such as gold, US Treasuries, and the Japanese yen as a way to protect their portfolios from potential losses.

Gold is considered by many a safe-haven asset because it has historically held its value during periods of economic and political uncertainty. In addition, gold is a tangible asset that is not tied to any specific country or government, making it a viable hedge against currency risk.

Is this true? Is gold really a risk on risk off asset? Let’s backtest to find out:

Let’s do the same backtest on gold as we did above for Bitcoin. We are invested in gold when S&P 500 is below its 15-day moving average:

Is gold risk on risk off?

Conversely, this is the equity curve when we flip the trading rules and are invested in gold when S&P 500 is above its 15-day moving average:

is gold a risk on asset?

From these two charts, it seems gold is a risk on asset.

Risk on risk off ETF

To our knowledge, no specific ETF tracks a risk on risk off model or portfolio.

Risk on risk off strategy – backtest and performance

Let’s go on to backtest a risk on risk off strategy. This is no easy task, but we give it a try.

We make the following trading rules:

  • We make a risk on risk off “index” of junk bonds (JNK), gold (GLD), S&P 500, emerging markets stocks (EEM), and Bitcoin (BTC).
  • When at least three of the mentioned assets are over its 200-day moving average, we are in “risk on” mode.
  • When less than tree assets are above its 200-day moving average, the mode is “risk off” and we are in cash.

It’s a very simplistic and “crude” strategy, but it still might work?

Let’s look at the statistics, results, and performance:

Risk on risk off strategy Bitcoin

We first backtest the risk on risk off strategy on Bitcoin:

Risk on risk off strategy performance

The 10 trades make an average gain of 258% which equals 123% annual gains (CAGR), substantially better than Buy&Hold’s 75%. The strategy is only invested 73% of the time, and we might argue the risk-adjusted return is 168% (how to calculate risk-adjusted returns).

Risk on risk off strategy stocks

Let’s see how S&P 500 fares with the risk on risk off regime filter (we backtest SPY):

Risk on risk off trading strategy for stocks

There are only 8 trades but the annual return is 12.9%, which equals 16.6% risk-adjusted return because the strategy is only invested 73% of the time. Buy&Hold was 12.4%. One other feature of the strategy is the much smaller max drawdown compared to buy and hold: 16% vs. 33%.

Risk on risk off trading strategy trading rules and code

If you become a silver member, you get the code for the strategy (plus hundreds of other trading strategy codes).

Risk on risk off trading strategy – conclusion

Other risk on risk off regime filters might be more useful than the one we used here – we just tipped our toes in unknown waters to learn more about the subject. However, simple trend and momentum filters like moving averages might be just as useful as other more “advanced” parameters we used in this article.

As always, make sure you develop your own trading rules for a risk on risk off trading strategy by backtesting.

FAQ:

What is “risk on risk off” in the financial markets?

“Risk on risk off” (RORO) refers to a market sentiment-driven strategy where investors shift between higher-risk and safer assets based on their perception of market risk. During “risk-on” periods, investors favor higher-yielding assets, while during “risk-off” periods, they move towards safer investments.

How does a risk on risk off strategy work?

A RORO strategy involves buying higher-risk assets during positive market sentiment and selling them during negative sentiment. Simultaneously, it includes buying safer assets during negative sentiment and selling them during positive sentiment, aiming to profit from shifts in investor risk appetite.

What are typical risk-on assets?

Typical risk-on assets include stocks, high-yield bonds, commodities (e.g., oil, copper, gold), emerging market currencies, and more recently, cryptocurrencies. These assets tend to perform well during positive market sentiment and economic growth.

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