The credit crunch taught us that there are institutions that are too big to fail or rather to be allowed to fail.  In March 2008 the US government through the Fed bailed out Bear Sterns one of the Wall Street stalwarts through wars, bubbles and depressions, but not the credit crunch of 2007/8.

This past weekend the US government bailed out two institutions at the heart of the American housing industry, Freddie Mac and Fannie Mae with the explicit message that they cannot be allowed to fail and pose a systemic risk to the whole financial system.  The mortgage and thus housing market will simply grind to a halt if that would happen.

The interesting question why these institutions are at such a risk of failure that extraordinary measures by the government must be taken to safeguard their continued existence is easily answered in one word:  LEVERAGE.

They are geared too high.  When the going is good leverage is all moonshine and roses but when the going gets tough being geared too high makes for a short terminal illness before the last rites are administered by the market.

Clearly from the recent history over-leveraging brought several companies that are too big to fail to their knees and they weren’t allowed to fail.  So how much of a good thing (in good times) is a bad thing in bad times? According to industry watchers Bear Stearns had gambled with 33:1 leverage.  Sooner or later, with this kind of leverage, no matter how clever you think you are, something nasty is going to happen.

Says one of the insiders that the leverage of the top five Wall Street firms increased during the last few years from 30:1 to 41:1 and that is before the billions of write-offs.

BIG BEAR, LITTLE YOU

Let’s make sure we have this right.  If you are a big lion like Bear Sterns you are too big to fail and thus even if you over indulge in the risky business of too high leverage you will be saved by the US government or if you move fast enough and preventively by an oil sheikdom’s sovereign wealth fund.

Now let’s focus a bit on your own retail forex trading account.  Who is going to bail this little cub out if she over indulges in the risky business of too high leverage?  Professor Bernanke?  Nope.  Mr Paulson?  Nope.  President Bush?  Nope.  The Abu Dhabi Investment Corporation?  Nope.  The CFTC & NFA?  Nope.  Your friendly forex broker who gave you the dynamite and matches to play with in the first place?  Nope.   

Ok, you get the picture, you are personally responsible and you are the one and only lender in last resort of your retail forex trading business.  You do see it as a business, right?  You do understand that all financial market business principles apply, right?

Ok, so why do you trade with leverage that makes the Bears, Lehmans, Freddies and Fannies of this world look downright conservative, like an interest bearing bank account?

Do you even know what your leverage is when you place that great GBPUSD trade late this morning which will be stopped out early this afternoon?

It is beyond my understanding, but for some reason most retail traders who, with all due respect, do not even understand the most basic concepts of leverage, namely how to calculate it, apparently believe that they are too small and too smart to fail. 

They apparently believe they can outsmart the smartest guys in the town when it comes to trading and make hundreds if not thousands of percentage returns per year by ignoring the principles of the trading business and adhering to the gibberish in the latest $499.00 trading course by another failed trader who stumbled upon the potential of Internet marketing. 

Apparently because they have a small account they think the rules of risk don’t apply, they are too small and too smart to fail.  The smaller the account the less relevant the rules of risk become, they think.  So they open an account of $200 with "leverage of 400:1" and fail.  Then they open a $2,000 account with "100:1 leverage" and fail again.

Well the billions and billions of write-offs on Wall Street confirm that the smartest guys in town are too big to fail and the 90% failure rate in retail forex trading confirms that retail traders are not too small to fail, (and not so smart too boot).

How can this benefit you?

I think the main benefit of this insight is that you should keep
in mind that even though you have a small trading account and that you can be very nimble, have all the advantages of the high leverage to access and even though you are a smart person you simply are not too small or too smart to fail.  In fact the odds that you will fail if you over indulge on leverage is very high and the odds that you will be bailed out by any third party is basically zero.

The most important risk management principle for retail forex traders is astute application of leverage.  If you still think you trade with 100:1, 200:1 or 400:1 leverage you should hasten to find out what your real leverage is and if you indeed do trade with any of those leverage ratio’s - may the Fed be with you, by golly you are going to need it.

Godspeed
DrForex
"Chance favours the low leveraged trader"

There are two types of “economics”, “professors’ economics” & “traders’ economics“.

If you want to apply “fundamentals” to currency trading you must be able to do what I call “relational analysis”. One of the foundations of relational analysis is “traders’ economics“.  Traders’ economics wont get you straight As for your PhD at Harvard but it might just keep you at the right side of the prevailing currency market trends.

Here is an example of traders’ economics and how to apply it and relational analysis as part of your currency market views.

Chicken or Egg?  What’s first? / High oil or low $$$?  What’s first?

I find this debate about the value of the low USD and the high oil pretty strange if not amusing and a bit silly.

In short there are a number of commentators and comments doing the round that oil is high because the dollar is weak and secondly calls from generally US patriots that the Fed must strengthen the USD to alleviate the oil problem, halt global warming and fix the hole in the Ozone layer too boot.

As if it is so simple as a central banker snapping his fingers and a currency take a sustained new path.

There was a time that especially Europeans were calling on the Fed / Americans to please, please stop saying they believe in a strong dollar policy but not doing anything about it.  Now the Fed is still believing in a strong dollar, realize they can’t do anything about it and pleads with everybody else to debase their currencies to help out the Fed!  What a joke.

Here is why.

These days oil clearly is more important for the day to day generally efficient
running of lives than for instance gold and as such in our world @ speed of
light oil is vastly more valuable for homo economicus, especially now that large parts of the global population are exponentially increasing their wealth and start amongst other things to buy motor cars at a hectic pace.  (I heard yesterday that China currently have less than 5 cars per 1000 people, the world average is just over 100 and the US is something like 760.)

You with me?

Now let’s see how truthful this story
that oil is high because the dollar is low is.

I suspect it is
bogus.

Oil is important and its importance is on the increase.  And
its importance is in its price. (The corollary is that the USD is losing value because it is losing importance in a globalized world where economic power is becoming more and more decentralized and this is also in the USD price.)

You see oil is as high as it is when expressed in US $$$ because the USD is weak.  (Now if you think oil is high in USD try buying a barrel of oil with your container of Zim $$$ -:) )

BUT, take AUD for instance.

For Ozzies oil is also high because it is valuable, scarce, in demand etc in Australia, but oil is not as high in Ozzie dollars as in USD.

What is the rise % wise of oil since the Iraq war
has started when expressed in AUD?  A quick glance at a chart of AUDUSD from March 2003 to July 2008 tells the story.

That is a 60% rise in AUD vs USD since the Iraq war.  Now if I understand the talking heads they reckon amongst others the Ozzies must weaken their currency against the USD in order for the oil price to drop.  I am confused!

You see, these days oil is high for everybody, but if you
pay for oil in USD (like everybody does) and you must exchange whatever you have for USD first to pay for your oil and you can
get more USD for what you have, then your oil costs relatively less. But if your currency
weakens against the USD you get less dollars and pay more for the oil you
want.  As I say, who in his right mind will voluntarily do that at this stage?

But
what you can do is to make sure you pay less by getting more USD for your
currency.  OK, that is not so easy to achieve for a central bank but what you
really won’t like to stand and defend even as a moronic politician is why you
debase the currency to make the stuff even more expensive … and that while almost every soft or hard commodity you have to buy is also at the top of its historic price levels?

How can this benefit you?

Well I think the main benefit of this insight is that you should keep
in mind that talk is cheap, oil not and when you have to pay money
(especially millions and billions) people usually make rational
decisions with their own self-interest at heart and they leave their
altruistic tendencies at home.

So, maybe you should just slightly re-weight the potential of a drop in
the oil price to make a big change in the value of the US dollar.

Godspeed
DrForex
“Chance favours the fundamentally prepared trader”