The Brexit trade is a great example of seeing how risk flows
When we trade it is always worth trying to get a feel for the "risk" factor in a market. I'm not talking risk as in the amount you put on a trade but on what the riskis to your trade strategy. It's price direction risk. We can also define it as risk/reward or value.
Over the last few weeks the pound has shown how risk has changed.
The move down to the 1.38's in cable was largely due to nervousness around the referendum. It came at a time that both Mike and I had highlighted we would likely start to see the vote playing out in the the quid. The pound fell down to some very long term lows, lows that I highlighted in Feb. In its simplest form, people saw market risk and sold the pound. When that trade ran out of steam where was the risk, reward or value? It wasn't with selling down there anymore. The risk was that the pound would go back up.
Now that the sentiment has changed, and more of the market now believes the UK will vote to stay, the trades have swung around. Those who were fearing an exit and sold the pound have unwound trades and so now we're some 800 pips from the lows. Where is the risk, reward and value now? Is it with jumping into longs up here?
For now, forget about what may happen at the vote. The exercise is to be able to look at a market and decide where the risk is in a price moving in one direction or another. Are you going to trade into the wind? If you are in a trade that is in your favour, is there a risk that there that it might not keep going in your direction?
Knowing this risk, reward and value balance can also help you understand the possible reaction to the Brexit result. If the market bias is towards staying, and it gets that result, how much more upside will the pound see before everyone starts taking profit? We saw exactly that over the Scottish referendum. The pound went higher when the first votes came in for staying but there was very limited upside when it was all over. The risk was then staying in long positions.
Based on the current sentiment on the vote, if the vote result came today we would see a smaller move higher on a stay vote than we would a drop on a leave vote. That's because the market is already leaning towards a stay result. If I was long into that result I would use any 'result' pop to get out. I would also move any stops right up to protect my profit in case of a leave vote.
If you can learn to understand this type of risk you can use it to help limit your actual monetary risk or increase (or keep) your profits.
Learn where the risk is
