Asymmetric Event Risk

Asymmetric Event Risk

"Asymmetric risk" is one of those terms economists like to throw around. It refers to a situation where the positive and negative risks (yes, risk can be both positive and negative) are not equal. Unequal risk is exactly what trader's are looking for - but only where the positives outweigh the negative.  And the two key events facing the market over the next 48 hours appear to offer just such a trading opportunity.

Profit to loss ratios greater than 1.5 to 1 are one of the keys to trading successfully over the long term. Traders usually create these through prudent stop loss and take profit ratios - and this is a perfect example of positive, asymmetric risk.

There are many other sources of positive, asymmetric risk. Buying options is another example. However, sometimes market positioning ahead of events, combined with analysis of likely market reactions, can offer a positive risk bias. Its my view that this is the case with both the ruling from the German Constitutional court due tonight, and the announcement from the US Fed's Open Market Committee tomorrow night.

In both cases, markets are expecting market supportive results, driving currency, share and commodity prices higher. Many commentators have argued that a negative ruling by the German court, or a lack of stimulus from the FOMC, will spark a sell off - but I disagree.

Its possible in both cases that a negative announcement could spark knee-jerk selling. However, in my view, any such selling is likely to be short lived.

In the case of the German court ruling, the ECB could change its plan to require distressed nations to apply to the ESM (the subject of the ruling) to the existing EFSF. The members of the Euro zone could simply extend the EFSF indefinitely, or until such time as the German government can put a referendum to the people. Markets will likely jump to this conclusion fairly quickly if the court rules the ESM unconstitutional.

Similarly, if the FOMC doesn't announce a stimulus package on Thursday night, markets are likely to expect an announcement next month, curtailing any extended sell off.

This represents asymmetric risk - the response to positive announcements could see sustained buying, the response to negative announcements may be short lived selling, if at all.

Clearly, this is of of key interest to investors and "swing" traders - those operating on a time frame of more than one day. Intraday traders may be able to take advantage if an initial sell off occurs.

The situation is different for every trader and investor. Those who use tighter stop losses may consider a "looser" stop loss order combined with a smaller position. Nonetheless, to me it makes sense to buy risk assets ahead of these announcements.