For active traders and investors, systematic risk is a market driver that should never be ignored. It can come on as a surprise and wreak havoc on even the most well-diversified portfolios. Let’s take a look at how astute market participants address and hedge against this type of risk.
What Is Systematic Risk?
Systematic risk is the chance of a broad-based market crash occurring at any point in time. Examples of such scenarios are the global financial crisis of 2008; the terrorist attacks of Sept. 11, 2001; and the coronavirus (COVID-19) pandemic of March 2020.
As you can see from the above examples, market crashes are products of diverse factors; some are clear-cut while others are obscure. For instance, during the market crash of Sept. 11, 2001, the attack on the World Trade Centers drove the risk of financial catastrophe. Conversely, the market meltdown of 2008 was a product of subprime lending and mortgage collateralization. However, no matter the type of crash, two attributes are constant:
- Surprise: Market crashes exist as outliers, surprising a majority of market participants. The results are often panic selling, euphoric buying, and overall irrational behavior.
- Pricing chaos: Amid a market meltdown, asset pricing becomes chaotic as participation levels and volatility spikes. Typically, the value of risk assets falls as safe havens gain market share. Further, currency values are significantly impacted as central banks and governments attempt to restore order in the marketplace.
Because of its mysterious nature, it is difficult to assign a hard value to systemic risk at any given time. However, there are ways to protect your portfolio from an unexpected financial meltdown on an ongoing basis.
Hedging Against Catastrophe
Despite the fact that market crashes are unexpected and rare, market participants constantly scrutinize systematic risk. Accordingly, there are many ways that traders and investors hedge against an unexpected market meltdown. Here are three tried-and-true methods for doing just that:
1. Buy the safe havens.
During market crashes, riskier assets are sold as investors flee to safety. This phenomenon has historically driven the value of safe-haven assets up as market participants bid them aggressively. Examples of traditional safe havens are gold, U.S. Treasuries, Swiss francs, and Japanese yen.
To hedge against an untimely market crash, most portfolios allocate capital to the safe havens. If the unexpected does occur, these positions help to mitigate the damage created by negative market performance.
2. Limit exposure to the U.S. dollar.
In addition to being legal tender in the United States, the U.S. dollar (USD) is the world’s reserve currency. Holding reserve currency status means that many commodities and foreign currencies are priced in terms of USD. Accordingly, if the global financial markets unexpectedly plunge, the USD is highly likely to experience bearish pressure during or in the aftermath of the crash.
For those involved in the U.S. markets, “hedging out” the USD is an ideal way of reducing systematic risk. This may be accomplished by adding one short position for every long position held in the U.S. markets. Going long agricultural commodities and foreign currencies are two ways of directly reducing USD exposure. If the USD tanks in response to a market crash, the prices of these assets will very likely rise over the short or intermediate term.
3. Trade futures spreads.
Futures spreads furnish traders and investors with a multitude of affordable ways of limiting aggregate market exposure. The combination of long and short positions featured by inter-commodity and intra-commodity spreads offer holders insurance against both market crashes and USD devaluation.
As an example, traders frequently use commodity spreads to trade a market opinion while vastly reducing risk. This is a major functional advantage because a trader’s bullish or bearish position is always covered in case the improbable comes to fruition.
Managing Risk Is the Name of the Game
The COVID-19 crash of March 2020 reminded us of the importance of systematic risk. Those who took heed weathered the storm and prospered; those who didn’t may have sustained massive losses. To learn more about the ins and outs of risk management, check out your complimentary copy of Daniels Trading’s Hedgucation 101 online guide.