By Lucas Lieu, Founder at AlgoTrading101
How can retail traders beat the institutional traders and hedge funds? Retail traders can target small, exotic and unregulated markets. We have no pressure to trade and can wait on the sidelines for good opportunities.
Our competition, the hedge funds and big trading firms, have billions in capital, teams of experienced and highly qualified portfolio managers, traders and analysts, cutting edge hardware and software infrastructure and real-time access to material market information.
We have a rusty old laptop, a free trading software, questionable Wi-Fi (and hopefully free power sockets at our corner cafe).
What chance do we have? Fortunately, the answer is… some.
7 Advantages retail traders have over institutional traders
- Small Capacity
- Exotic and Unregulated Markets
- No Pressure to Trade
- Lack of Investment Mandate
- Low Execution Risk
- No Capital Withdrawals
- No Disclosure Required
5 Disadvantages retail traders have compared to institutional traders
- Lower Fees, Spreads and Interest
- Best Services and Wide Range of Products
- Fast Information
- Top Technology
1. Small Capacity
Hedge funds have large capital and this limits the markets they can access.
Some stocks are too small to absorb their size. If a hedge fund buys a significant position in those companies, they will pump the stock up inadvertently.
As individual traders, we can fly under the radar and tackle markets that don’t have enough liquidity to absorb the big boys.
2. Exotic and Unregulated Markets
Big funds are regulated by government agencies. They can only put their capital in certain approved markets – futures, stocks, Forex trading etc.
We can trade any products. Go for exotic and unregulated markets instead of the common crowded markets.
- Cryptocurrencies? Go for it.
- Stock market in developing countries? Go for it.
- Unregulated derivatives? Go for it.
3. No Pressure to Trade
Strategies come and go. The average lifespan of a strategy is about 1 to 3 years. What should we do when our strategy dies?
We research and develop new ideas (note: you should be developing new ideas even when you have a working strategy).
Don’t try to force a trade when there is none!
Funds have pressure to deploy their capital. They might get in trouble with their investors if they don’t deploy their cash.
Thus, they might be forced to make sub-par trades. Unlike us, they don’t have the luxury to sit and wait for the perfect opportunity to pounce.
4. Lack of Investment Mandate
Some hedge funds and most asset management firms have investment mandates they have to follow.
A Long-only Asian Equity Fund has to absorb the beta risk of Asian equities (unless they hold 100% cash which is unlikely) even if they are bearish on Asian Equities.
Retail traders on the other hand can adapt their play to the varying market conditions.
5. Low Execution Risk
Imagine if an asset management fund wants to buy a significant stake into Company Banana. This will definitely move the market.
Other players may notice and join the trade. This pushes the price higher and raises the fund’s entry price.
Retails traders rarely move the market. Rarely do people care what they do – maybe except for this guy: https://www.bloomberg.com/news/articles/2014-09-25/mystery-man-moving-japan-made-more-than-1-million-trades
6. No Capital Withdrawals
Capital withdrawals tend to be disruptive to the investment strategy. Investor withdrawals may cause the fund manager to liquidate his holdings to raise cash.
This is especially disruptive if the asset liquidated is illiquid since cost of liquidation is high (executing at bad prices and paying up bid-ask spreads etc).
We don’t face such problems.
7. No Disclosure Required
Large funds that are regulated have to disclose some information on their holdings. This makes it more difficult for them to outmanoeuvre the market.
Our trades are hidden. Though, unless we are consistently profitable over many years, no one is really going to care about our trades =/.
1. Lower Fees, Spreads and Interest
Big funds have better bargaining power and can negotiate lower execution cost, commission rebates and shorting or margin fees.
Retail traders generally pay higher commission, spreads and fees.
2. Best Services and Wide Range of Products
Big funds have access to prime brokerage, other support services and a wide range of financial products.
These support services spend countless hours researching and executing the best deals for the funds. Retail traders do not have this luxury.
Moreover, some institutional traders have special agreement with brokerages to act as specialised market makers. They get better information and trading terms.
3. Fast Information
Information is king. Funds have access to important information quicker than the general public. This gives them an edge.
4. Top Technology
Big funds invest top dollar into better infrastructure. These infrastructure aids their trading in terms of research/backtesting, execution and risk management.
This allows them to engage in complex trades that the retail traders cannot access.
This is why retail traders don’t enter the world of high-frequency trading. The infrastructure costs could go up to hundreds of millions, and that doesn’t even guarantee success.
Funds have better credit rating than the average retail trader. Hence, they are able to get better leverage and terms. This allows them to weather tough times and increase returns with a smaller base capital.
How can retail traders be successful
Once we understand the different circumstances between the big boys and us, we should realise that the real question here is not “How do we outwit the big funds?”. It is “How do we find market inefficiencies that are untouched by the funds”.
Google will not touch a $20,000 per month revenue opportunity – it is too small. However, this is big enough for a one-man tech company.
Similarly, Bridgewater (a big hedge fund) will not touch a penny stock that has $300,000 daily trading volume (and no that’s not a lot). Making $1,000 a day is not worth their time. But you and I probably won’t mind an extra $1,000 a day.
We should look for new and/or exotic markets, for unregulated markets, for new ways to evaluate opportunities that aren’t done or taught before.
Creativity is your biggest weapon.
We don’t have to beat them to be successful. Keep targeting these pockets of alpha in the market, until we grow big enough to play in the same playground as the big boys.