There are reasons assets rise and fall. If you don’t understand those reasons, picking assets is like throwing darts at a dartboard. It’s all a gamble. You need not take those kinds of risks. Indeed, it’s essential you understand the risks of trading and protect yourself by staying within your risk tolerance. As you learn about events and trends that move assets, you can become better prepared to invest wisely.
3.1 Understanding Market Cycles
Market cycles and trends are used to help investors predict the market. They are easy to see looking back, but much harder to pinpoint as they occur. Traders study technical analyses to try to understand how the market will move next. For the most part, professional investors follow the trend until it changes. They have a saying, ‘The trend is your friend’.
What Causes a Market Cycle? The expansion and contraction of business, earnings, inflation, stability, and politics all affect market cycles. Basic human emotions and behaviors create market trends.17 People swing between fear and greed, between focusing on the good news and worrying about the negative. Markets react to the pendulum-like swing.
Economic Cycle: The most generic of all cycles is the economic one. It’s divided into four parts:
- Market bottom and full recession
- Bull market and recovering economy
- Market top when the curve levels out and there is high expectation but less production
- Bear market with the economy falling toward a recession
Kinds of Market Cycles: The length of a cycle and its beginning and end point are especially hard to see as they are occurring. The trend is easier to determine as you look at charts and historical data.
- A Bull Market is a series of up-trends. You see higher highs and higher lows.
- A Bear Market is a down trend. It’s characterised by lower highs and lower lows.
- A Revision to the Mean is the natural tendency of securities to come back to the norm as shown on long term charts.
- A Sideways market is when the price bounces up and down but stays within a channel. This may show up at any point in a cycle. In the middle of a trend, it’s called a consolidation.
Companies may gain high valuations in a bull market, or low ones in a bear market, but some schools of thought believe secular cycles revert to the dominant P/E ratio.18
Different investments can be in different cycles at the same time. Often consumer staples will be in an uptrend while technology is in a downtrend. Or the financials may be trending up while commodities are trending down. Savvy investors capitalise on these trends by shifting their assets away from a down-trending sector and into an up-trending sector. But entering a trend too early or too late will reduce profits and can result in losses.
Secular cycles can last decades. Cyclical cycles range around four years and within each cycle there will be many temporary dips or reversals. It takes skill to know if these dips indicate a change in the cycle or are just variations of the same trend. Traders may buy and sell on these smaller changes. Short cycles include things like:
- The January Effect
- Sell in May and Go Away
- Options expiration dates
- Monthly reports on employment, inflation, and other data19
Long term investors exercise patience and hold their course during the short reversals. Understanding the basics of technical analysis may help investors spot trends and places where the market is likely to change direction.
Traders who are worried that the trend might suddenly change sometimes may place puts, calls or invest in a Contract for Difference (CFD) as insurance against that change.
3.2 Trading the News and Economic Calendar
Stocks, currencies, and commodities all respond to news, both predicted and unexpected. Because you understand that trends will eventually revert to the mean, or back to the trend, you may be able to take advantage of unexpected news. The knee-jerk response of bad news may cause a sudden drop in a security. Often it’s an overreaction and the security will bounce back. But not always. Knowing the fundamental value of the security will help you know if a news-related dip is a buying opportunity or not. Understanding the underlying strength or weakness of a currency may guide your investment decisions during a surprising change.
Company news: Companies distribute reports and dividends on a calendar schedule. Options or CFD traders often trade before the news based on their estimate of the outcome. Volatility usually spikes before earnings reports. If the equity trades within the expected range, traders can capture that premium as the volatility drops after earnings.
Options Expiration Dates: If the stock market has made major changes, those who have shorted equities may need to cover those shorts. It can cause a temporary dip or rise in the equity price. In a similar way, index funds rebalance their portfolios on specific dates. This too, can affect the prices of those equities held within the index fund.
Economic Calendar: There are many dates where economic reports are delivered. Many of these reports are used to assess the health of the economy. Based on these measurements or statements, the market tries to predict how securities will move. Some of these include:
- Commodities Future Trading Commission net positions (CFTC)
- Consumer Confidence
- Consumer Price Index (CPI)
- Federal Reserve Board minutes- affects U.S. interest rates
- German Buba Monthly Report
- House Pricing Index
- Jobless Claims
- Markit Manufacturing PMI
- Producer Price Index- measures inflation for businesses
- Retail Sales20
“You’re trading the largest markets in the world with trillions of dollars being traded every day, it’s you against the millions of other traders out there and it’s the biggest challenge you will probably ever face, to become one of the 5% who actually make money from trading and that’s why I love it. — fxchartstudies, eToro Popular Investor
You can find a more complete list at eToro’s economic calendar.
When nations report on their gross domestic production, their debt, employment, housing, manufacturing, import/export levels, consumer confidence, and more, investors gain understanding about the direction of the economy. As financial institutions comment on business trends such as inflation levels, interest rates, oil supplies, and cost of goods, traders adjust expectations for business growth.
3.3 Risk vs. Reward
When you invest, you’ll often find a trade-off between risk and reward. Sometimes that trade-off is obvious. Sometimes it’s hidden.
Traditionally, bank savings were viewed as the most risk free investment. You would earn fixed or various interest on the money you put into the bank. However with negative interest rates and increasing bank failures, banks may no longer be considered risk-free.
Bonds have been another asset class that has been labeled ‘low risk.’ If you purchase a bond and hold it to maturity, you are guaranteed to get your money back and the additional percentage of interest paid. That is provided the holder has not defaulted. Depending on inflation, your bond may or may not actually earn you any money.
Investing in blue chip stock companies has also been considered fairly safe. These large, international, well-funded companies produce needed services and pay dividends. They most often weather financial storms. The stock price may fluctuate, but traditionally, they have offered good returns for the investor.
Smaller companies, those in emerging countries, and those with larger debt offer added risks. Small companies may not have the depth to weather adversity. Emerging countries may face unrest, shortages, or unfavourable exchange rates. Companies with large debts may find they cannot raise capital during a setback.
The more uncertainty, the more likely you are to lose money or to lose your entire investment.
Statistic Brain Research Institute says only 37-58% of start-up companies are alive in four years.21 If the company fails, you lose all your money. On the other hand, if the company becomes an Apple or Google you stand to make many times your original investment.
Commodities may offer the security of tangible assets. But they are most frequently traded on paper. CFDs can help capture the change in price without the risk of physical storage. Different kinds of commodities carry different risks. Cycles influence commodity prices.
Currency typically has small movements so it might be deemed safer. But traders usually leverage their trades to try for larger gains, which significantly increases risk.
Leveraging a trade means you use a lower percentage of invested money to control a larger amount of a financial instrument. This increases your chances for both larger profits and larger losses. You increase your risk. CFDs, Forex, and short options trading use leverage. In these cases, it’s possible to lose more than your total investment and be left with a large debt.
When traders can afford to lose all their money, they can trade with a higher degree of risk in the hopes of making an outsized return. People who cannot afford to lose their money should trade in a more conservative way with lower risk instruments. They exchange increased safety for lower returns.
On the other hand, many people, over the long run, have made substantial returns on low risk investments. So low risk does not always mean low returns. Investment platforms may help you find out the risk of the trade before you choose to make it.
The Cost of a Loss: When you take a loss, sometimes called a drawdown, it takes more gain to recover. If a security drops 50%, it doesn’t just take a 50% gain in the price to bring you back to even. It takes a 100% gain to even you out. Here is a chart of the gains needed to return to even on unleveraged instruments.
|Portfolio Loss||Gain needed to bring back to even|
If you choose to invest in leveraged securities, the required gain is much steeper. At 5x leveraging, a 10% drop will need a 100% gain to break even. And a 25% drop would need a 300% gain to eliminate your losses.
Ask yourself, how will I feel if I lose money on this trade? How much can I afford to lose before it affects my future, my retirement, or my emotional well-being? This will help you assess your risk tolerance. If you find yourself watching the prices and sweating every time there’s a dip, you may need to lower your risk tolerance and choose safer investments. It should be fun, not stressful.
3.4 Risk Score
eToro offers a simple tool to assess the risk level of a portfolio or investment. Click on your public profile in your active trading site to see your Risk Score. It tells you the level of risk in your investments. If you have a private profile, you must make it public to see your score. (A public profile shows what you are investing in, but never the amount of you investment.) You’ll also see this risk score in the Popular Investor’s page so you can choose to copy people with a similar risk tolerance.
The Risk Score is a reminder that all trading involves risk. You should only risk capital you’re prepared to lose. Also remember that past performance does not guarantee future results. While these traders may have produced outstanding results for the past 12 months, you cannot assume the next 12 months will bring the same results. However, as an investor, you are now better prepared to understand the risks you are taking should you trade alongside them.
This is another step eToro makes to be transparent and keep investors informed. When you click on a Popular Investor’s page, it will take you deeper. You’ll see a chart with their past trades and the risks associated with those trades.
When you scroll over a bar, a pop-up tells you the maximum risk and the average risk of the trades for that month.
The max drawdown below the graph shows the highest historic losses the trader has incurred during the previous 12 months, by day, by week and aggregated yearly. This shows the performance of the trader for you to consider if you are willing to tolerate the risk for the potential upside gains. The low risk scoring Fabian Marco brought in 20.50% profit over this trading period. The popular investor Sergejs Kovalonoks profited 14.13% over the year of 2018.
The Risk Score is created from a proprietary algorithm that assesses the portfolio’s overall exposure from each of the trades open. It takes into account the daily movement of a security. Then it multiplies the chances of volatility so the range will be accurate 99% of the time. Leverage increases the risk. But some combinations of securities actually reduce risk. If you pair two currencies (for example the EUR/USD and the USD/JPY) you hedge the USD no matter if it goes up or down. These kinds of paired trades lower the overall portfolio risk and so may lower the risk score.
eToro’s risk scores help you understand and manage your risk in a less emotional and more quantified way. When you understand how the markets can cycle and how to control your tolerance for risk, you gain the confidence to trade and invest. The next step is to learn how to research assets to be able to pick strong ones.
This is a marketing communication and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without having regard to any particular investment objectives or financial situation, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication, which has been prepared utilizing publicly-available information.
eToro is a multi-asset platform which offers both investing in stocks and cryptoassets, as well as trading CFDs.
17 Litman Gregory Team, ‘Market Cycles and Portfolio Positioning’, Advisor Perspective. 26 Apr. 2016 https://www.advisorperspectives.com/commentaries/2016/04/26/market-cycles-and-portfolio-positioning
18 Easterling, Ed. ‘Understanding Secular Stock Market Cycles’, Crestmont Research, 7 Oct 16 https://www.advisorperspectives.com/commentaries/2016/10/07/understanding-secular-stock-market-cycles
19 ‘Stock Market Cycles’, Wikipedia. https://en.wikipedia.org/wiki/Stock_market_cycles
20 FX Street Economic Calendar https://www.fxstreet.com/economic-calendar
21 Pryor, Kristin. ‘Here Are the Startup Failure Rates by Industry’, Tech.Co 12 Jan 2016 http://tech.co/startup-failure-rates-industry-2016-01