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Whetting the Risk Appetite


Say, maybe I can finally make some lunch money!


A common topic on Minyanville is investor preference. Whether it's time or risk, trying to gauge where investors' preferences are is a worthy and typically profitable endeavor if you hit it about right.

I concentrate on monitoring various measures of traders' risk appetites. It's a difficult thing to do, as we have to make many assumptions - both in terms of what we're actually looking at, and also in terms of what it could mean going forward.

Even with those challenges, we can still find measures which perform consistently in finding extremes of risk-taking or risk-avoidance. Generally, we want to take the other side of those extremes. When traders are excessively risk-averse (ala mid-April), we want to be risk-taking; when traders are taking on excessive risk, we want to be risk-averse.

The chart below is one measure that monitors risk appetite. It is what I call the SPY Liquidity Premium and is something I've shown several times before. I find it interesting because it compares the volume in the S&P 500 exchange-traded fund, SPY, to the volume in the underlying components of the index. When traders flee to the relative "safety" of an ETF, we know they are risk-averse (i.e. trying to avoid non-systemic, or company-specific, risk). We saw that several times over the past year, as the green highlights show.

We've also seen several instances where traders are comfortable with stock-specific risk. We assume that's the case when the Liquidity Premium is near its upper bounds. The concern is that that's where we are now - near the upper end of where this indicator typically turns around. The implication is that traders have become overly comfortable holding individual equities and are taking on excessive risk.

Whether that's actually the case or not, I don't know - as I said, we're making some pretty big assumptions here. But as long as the indicator continues its consistent track record, I'm OK with making a few assumptions. I'm still holding about ½ of the long position I wrote about in April, but becoming increasingly wary that the road is going to be a lot more rocky than it has been.

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No positions in stocks mentioned.

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