An important aspect about life is the need to learn from it. People who are successful attribute it to the fact that they went through challenges and learnt from everything in it.
For investors and traders, it is very important to learn from the past crashes. This will help them avoid repeating the same mistakes.
This article looks at some of the past crashes and the lessons we can learn from them.
Three Key Financial Crashes (+Key Lessons)
Long Term Capital Management (LTCM)
LTCM was one of the largest hedge funds in the United States. It had more than $126 billion in assets under management. Its growth was attributed to the fact that its founders and senior managers were top economists who had won various Nobel prizes.
These were the leading investors if their time, and to invest in the firm, the minimum amount was $10 million.
After careful analysis, the managers came up with the opinion on hedging against the predictable range of volatility in the foreign currencies and bonds.
The decision by Russia to devalue its currency led to increased volatility, with the US market declining by more than 20%, while European markets fell by 35%.
As the LTCM thesis crumbled, the fund collapsed. This led to intervention by the Federal Reserve Bank of New York, which forced banks to bail out the funds.
The collapse of LTCM is an important lesson that the prediction of so-called experts are usually not always accurate (one of the mistakes we suggest to avoid).
Barings was one of the biggest banks in the United Kingdom. The bank collapsed in 1995, when a rogue trader known as Nick Leeson lost more than $1.3 billion in unauthorized trades.
In his book, Leeson said that the bank’s senior managers put pressure on the traders to do whatever it takes to generate profits for the bank.
At the time, he was only authorized to do arbitrage trading of the Nikkei 225 futures contract. This arbitrage was mostly because of the differential pricing of the futures in Japan and in Singapore.
Instead of doing arbitrage by placing the trades simultaneously, he held his two contracts. He then hoped to make a larger profit by betting on the directional moves. To hide his losses, he used various accounting tricks. When the bank collapsed, he was sentenced to more than 7 years.
The lesson here is on the need to avoid being greedy in the market.
Metallgesellschaft was one of the biggest conglomerates in Germany with more than 20,000 employees and more than $10 billion in annual revenues. The company’s subsidiaries totaled more than 250 and specialized in chemicals, trading, finance, and engineering among others.
In 1993, after its hedging strategies failed, the company made a loss of more than $1.3 billion. When the spot prices of commodities declined, it led to margin calls. The company was latter bought for a song by GEA Group.
The lesson of this is that hedging strategies in trading can go wrong. For this reason, you should take time to study and understand the hedging field before you venture into it.
→ How to use Hedging Trading
Lessons from Past Flash Crashes
October 19, 1987 started like an ordinary day in Wall Street. But, by the events that happened that day will reverberate for years to come. Out of the blues, the market which were rising tanked. The U.S. markets fell by 22.68%, the Canadian market by 22.5% and the Hong Kong market by 45%.
The reason for the crash was not immediately known but the markets rallied later.
The same happened on September 11th, 2001 when the United States was attacked. The markets fell by double digits before recovering in the following days.
The same happened on May 6th, 2010 when out of the blues, the markets fell when a guy from London manipulated the market. That day, the Dow fell by more than 500 points before recovering minutes later.
A similar – albeit – smaller event happened at the end of 2017 when an ABC News reporter reported crucial information about the Russian investigation. The reporter claimed that during the election, Trump asked Mike Flynn to contact Russians.
The Dow fell by 350 points and the NASDAQ by 105 points. The markets recovered slightly when ABC clarified the news later.
While we can’t predict whether such flash crashes will happen in future, chances are that they will. We can’t predict when, but we are mostly certain that they will. This is because as the market becomes increasingly automated, such happenings will continue.
Therefore, as a trader, you need to know several things.
When a flash crash happens, all – including the pro traders – are caught off-guard.
They are caught unawares because, no one can accurately predict that such a crash will happen. No algorithm or artificial intelligence tool can predict if or when such a crash will happen. They just happen. So, everyone is usually caught unawares, and most people lose a fortune when such a thing happens.
The thinking of a flash crash is the key foundation of having a stop loss.
A stop loss helps protect an account when such a thing happens. For example, assume you bought the stock of a company at $15. Then, if there is a flash crash and the stock falls to $10, a stop loss at $13 will help protect your account from total loss. Therefore, you should always have a stop loss to protect your account from such a flash crash (How to do it in PPro8).
The idea of a flash crash applies very much when you think about risk management.
Risk Management a topic We have talked about several times before.
The concept is simple: when you open a trade, you should think about the maximum loss you can make and the maximum profit.
For example, assume you bought a bitcoin when it was trading at $300. At that time, the biggest loss you would have made would have been $300 if bitcoin dropped to 0. However, the bitcoin is currently trading at $11,500 which means that your profit would have been infinite.
The same thing happens in trading! You should always do your risk analysis before you initiate your trades.
When a big movement happens, you should not always rush to exit.
This is because a reversal can happen. This has proven to be the case when a flash crash happens. Immediately, the market falls but later on recovers. Therefore, if you see a major market crash, and you have your trades on, if the stop loss is not hit, you can continue holding on the position.
This is because a reversal can always happen.
Finally, flash crashes teach us that no one knows everything. In other words, there are no market pros. If they existed, they would warn us about them.