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?
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.
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