The Process of Risk Transfer

Gil Ecker, Technical Market Analyst, Trader

All rights reserved { getrade8@gmail.com }

– 20 July 2017 –

Think of a company that is about to get a big innovative project.

The headlines in the media are glowing, concentrating on the big potential, and the company’s stock is rising accordingly.

Who sells this big potential to these many buyers? Why should anyone sell?

Stakeholders, being close to this company weigh the other side of the coin. There is a risk here.

Suppose for example that this big project’s technology isn’t stable and mature yet, so everything gets stuck. Are they going to take that risk? Well, not when there is a wonderful tool that gives you the ability to hedge yourself and stay break even if you fail in your real business, called “The Equity Market”.

To hedge their risk, they sell some of their shares to the level that had the project failed, buying them again cheaper would compensate for the project’s failure business cost (technically, they shorted their market).

On the other hand, suppose the project does succeed and becomes profitable. They truly lose a potential profit on the stocks they had already sold cheaper. But now, they are being compensated by their real business activity, as their project becomes a money machine!

If their role in the financial markets is to sell you their risk, in order to protect themselves from a failure in their real business, then:

What is your role in the market, not being a stakeholder?

Your role in the market is to be a risk taker.

Your reward might be the potential profits, but don’t forget that somebody, in the know, sold you shares/commodity/currency etc, while it is obvious that had he known there wasn’t any risk or uncertainty justifying it, he wouldn’t have sold you these equities. No professional in the market is so generous to give you gifts.

The issue might be understood dealing with long term investments, where the real business activity needs hedging.

But is it limited only to that? What about already being in a profitable position?

Think just like a professional. You have your unrealized profits, and currently you see a further potential for the current move, though much riskier. What do you do in order to hedge your profits?

As an example how the risk transfer process is related to the basic of trading, let’s have a look on the NZD/CHF currencies lately, on a weekly chart.

NZD/CHF: a Weekly chart. Demonstrating the process of Risk Transfer

at courtesy of prorealtime.com

The reason for the current behavior can be any reason: Economical, Political, a good sentiment for the Swiss Franc, bad one for the New Zealand Dollar, etc. Perhaps some professionals acted by one of these hidden reasons.

Let’s concentrate only on technical matters. The 50 Simple Moving Average (grey line) declines which means that we are in a downtrend for this timeframe.

Professionals, already bought the bullish behavior on the left hand side of the chart for whatever reason, know that the market is in a downtrend, and approaching an important moving average. Their natural activity would be to hedge their profitable position, i.e. to sell amount of their position in order to secure their profit (This process takes place in the yellow rectangle).

Does it mean that this equity cannot jump over the moving average and skyrocket? Sure it can. But there is a risk attached to it, a risk that might not worth it, causing their whole profitable position turn into a losing one!

The real challenge with the moving average comes to a climactic activity shown in the pink colored stage. The price closes below the moving average, followed by a reaction. The market has shown its bearishness.

The last stage appears on the green rectangle, is the stage where the professionals, knowing at that point that by most chances the market is about to turn down, cover most if not all of their Long position (going short here is a different issue not related to the original position example).

See how the price manipulation caught many risk takers on the wrong side of the market! The bars look so bullish, tempting to buy.

The same process repeats itself over and over again on all timeframes, although not visually the same.

Every halt or correction that you see in any price move is eventually some kind of a risk transfer process, whether it ends by proceeding the original trend (“the project succeeds”) or by turning into a complete reversal, starting a contrary trend (“the project failed”).

This process ends a bullish market turning it into a bears market, and vice versa.

For any reason, technical, fundamental, political, macro economical, weather, etc, a turn is finally made, keeping the professionals being hedged, and the unprofessional dreaming about their potential profits.

Next time when you feel comfortable to click the Buy or the Sell button, for whatever reason and justification, should you ask yourself who there is in the other side, selling you the equities you want to buy / buying as you sell short.

Are they professionals transferring you a risk you didn’t take into account?

So, risk taker, better take care!

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