14 September 2015

How to manoeuvre through heightened geopolitical uncertainty

​Geopolitics and financial markets are inextricably linked, but there are risk management tools traders can turn to.
​​​​​​​​​​​​​​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 Syria and Iran 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 invest​ors 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 2014. 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 vulnerab​​le 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 2014. Natural gas prices spiked in February 2014 when Russia, Europe’s main supplier, annexed Crimea. 

But geopolitical events are not limited to armed conflicts. Political instability, for example Brazil’s expanding budget deficit and considerable debt load​, 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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The value of your investments can go down as well as up.
Losses can exceed deposits on margin products. Please ensure you understand the risks.