How to Manoeuvre Through Heightened Uncertainty

November 10th, 2014
in contributors

by Saxo Capital Markets

Geopolitical events around the world are dominating the news agenda and increasing volatility in financial markets. But why is this?

Why do events that occur thousands of miles away from western financial districts and seemingly unrelated to equity, bond and core currency markets have such a dramatic effect?

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For example, the recent conflicts in Iraq (and now Syria) and Ukraine both seem fairly detached from Western Europe and the US but stock markets, currency markets and commodities have all been affected.

Instability - of whatever type - makes it harder for investors to predict likely outcomes. This makes them nervous and increasingly risk-averse, which increases market volatility.

The traditional response is to move capital out of riskier assets like stocks and currencies, causing a market decline, and into what are considered 'safe haven' investments such as government bonds and gold.

Potential disruption to oil supplies caused by Islamic State's recent advance into Iraq and Syria saw crude oil prices hit yearly highs in June. Photo: Shutterstock

What this means for traders

Geopolitical events can be extremely difficult to predict and it is unlikely markets will get much advance warning. The best way for traders to deal with the resulting volatility is to ensure they have the appropriate risk management measures in place.

Certain sectors tend to be more vulnerable than others. In the cases of Iraq, Syria and Ukraine/Russia, the energy sector is most exposed. In Iraq and Syria, potential disruption to oil supplies saw crude oil prices hit yearly highs in June. Natural gas prices spiked in February when Russia, Europe's main supplier, annexed Crimea.

But geopolitical events are not limited to armed conflicts. Political instability, for example Argentina's debt default in July, or the collapse of a financial institution, such as Portugal's Banco Espírito Santo SA, can also cause ripples that will be felt throughout the global markets.

5 risk management tools to help manage geopolitical risk

1. Use stop losses

Effective use of stop losses can both automatically limit the downside risk of your financial positions while protecting open profits on existing positions.

2. Careful position sizing

By reducing the percentage of capital at risk during volatile market conditions, traders can preserve their capital for when market conditions are favourable again.

3. Manage portfolio 'heat'

By limiting the number of open positions at a given time, traders can reduce the overall risk to their portfolio.

4. Manage sector 'heat'

Avoid focusing trades on one specific sector, especially those that could be vulnerable to geopolitical risk (for example energy, transportation and tourism).

5. Cash is a position

If volatility becomes unmanageable, it is always possible to 'go to cash' and stay out of the market for a brief period until volatility calms. However, this approach risks trying to time the market; selling at a low price, buying back in at a higher price.

Geopolitical events can unfold very quickly and have a dramatic effect on financial markets so traders need to be prepared for bouts of sudden-onset volatility. Under such circumstances, closely monitoring market exposure is vital for capital preservation.

Disclaimer: This material should be considered as a marketing communication under the Financial Conduct Authority's rules. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research, nor is it subject to any prohibition on dealing ahead of the dissemination of investment research. Saxo Capital Markets UK Limited ("SCML") undertakes reasonable efforts to ensure that any information published in this communication is reliable. SCML makes no representation or warranty, or assumes no liability, for the accuracy or completeness of any information contained in in this communication.

SCML provides an execution only service and this communication does not take into account any particular recipient's investment objectives, special investment goals, financial situation, and special needs and demands and nothing herein is intended as a recommendation for any recipient to invest or divest in a particular manner and SCML assumes no liability for any recipient sustaining a loss from trading in accordance with a perceived recommendation.

Saxo Capital Markets UK Limited is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871

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