As a forex trader, what can you learn from the US Banking Crisis of 2008?
One thing you might be more inclined to understand more than the general public is the fact that the banks were trading on leverage. Investment banks were trading with 40:1 leverage in some cases.
The banking crisis in the US was caused by banks not buying based on solid fundamentals and using insane leverage to buy securities.
As a forex trader, no matter which system you are using to trade, it’s important that you understand the fundamentals of the currencies you are trading. Even if you are a technical trader, you still need to know what you are buying and selling. The investment banks in the United States made the mistake of not knowing what they were buying, and buying on extreme leverage. They needed the US Government to help them stay alive after the losses.
Forex traders do not have a government or lender that will back them up when they use too much leverage and don’t understand fundamentals. The big Investment banks in the US are a perfect example of what not to do. They have provided a free lesson for current day forex traders.
Let’s discuss in detail the two big rules that were violated.
Extensive use of leverage
Leverage is meant to be saved for a low risk, high return opportunity. When markets are at extremes, whether it’s good or bad for your account, it’s time to lower some of that leverage and take some profits. These investment banks continued to use up every ounce of leverage as the markets they were trading were in euphoria. It only took a quick flip turn of that euphoria and that leverage started to wipe the banks out.
A good general rule of thumb is when markets are at extremes, risk should be lowered. The US investment banks should have been scaling back and being conservative with markets at extremes. They kept the pedal to the metal, until the pedal broke off and took their foot with it.
Understanding Fundamentals
Fundamentals are supporting factors to buy or sell something. If something has good fundamentals, you would want to buy it because it will likely appreciate in value. If something has poor fundamentals, you would probably want to sell it or trade against it to make money as it falls in value.
The US Investment banks bought packaged securities that were not regulated in price and were full of individual securities that came from a booming real estate market that was out of control. The market was at extremes that were far away from prices that were supported by economic fundamentals. Once the euphoria evaporated, these investment banks were stuck with these highly leveraged positions that they could not value because the fundamentals were so far off. The only thing they could do was hold to them as they were likely falling in value, or sell them at an extreme loss if they could find a buyer.
Take these two lessons from the US banks. Stick to your trading rules, even when things seem fun. The government won’t be showing up at your door with a check if you make a mistake.