December 3, 2012

David Versus Goliath

Retail traders are the David's of the FX world, taking on the Goliath's that are banks and institutions. This article takes a pragmatic view of what retail traders are up against and where they fit in. There are ways that David can beat Goliath; the secret is having a clear strategy that plays to your strengths.

Technological progress has facilitated a huge opportunity for individual traders and investors. The Internet, in particular, has allowed anyone with a PC to access any tradable financial market.

The big impact of more accessibility has been the evolution of online trading from a relatively small niche industry into one of the fastest-growing industries in the world today. 

It’s now possible for anyone to open a trading account online and be able to trade almost any financial instrument including sophisticated contingent liability investments such as futures and options. Just a decade ago, the individual’s ability to partake in the futures and options markets was simply unattainable due to the high cost and lack of technological accessibility. 

Today, even someone with no trading or financial markets’ experience whatsoever can obtain Direct Market Access (DMA) to exchanges such as CBOT, CME and LSE whilst paying fees not too dissimilar to those paid by multinational banks and conglomerates.

Despite being a positive step for competition and consumer choice, greater market access for the individual has grown much faster than the individuals’ understanding of market forces. So, as more retail traders are able to access sophisticated markets, they are doing so without fully understanding the complexities of trading. In other words, trading may seem like a glorious activity that provides a variety of positive externalities, but in reality, financial markets are full of experienced and extremely sophisticated market participants that are not only bigger but also smarter in how they trade. As a result, most novice traders have been hugely unsuccessful in trading precisely because they haven’t taken the time and effort to fully understand the ocean in which they have decided to take a swim.

One of the biggest pitfalls for individual traders is leverage: the ability to take on large positions but only providing a tiny percentage of the capital requirement needed to do so. 

All retail brokers offer their clients the ability to leverage their trading account by up to 500 times the actual amount they are investing whilst sustaining profits or losses as if they had invested the whole nominal amount themselves. 

Retail brokers offer this to attract people with a small amount of capital but with large profit expectations and end up receiving a lot of flak for doing so. Most novice traders buy into this concept and actually prefer brokers who can offer higher leverage rather than seeing through the sales pitch and trading the appropriate volume given their account size. As a comparison, hedge funds and investment managers tend to use between 5:1 and 10:1 leverage as a rule of thumb – quite a difference when compared to the retail market which uses 100:1, with some brokers providing 500:1.

Individuals tend to favour day trading and more specifically scalping as a trading strategy which puts them at a disadvantage to other larger, better-equipped market participants. When opening a new trading account, most brokers will never admit to their clients that what they’re walking into is none other than a David versus Goliath battle – especially if the trading style is short-term, opportunistic and reactionary to changing events around the globe.

What most retail traders don’t realise when they try to trade economic announcements, comments from central bankers and earnings reports is that there are millions of other people trying to get onto the same price, at the same time as they are. 

For every buyer, there must be a seller which means that over a significant event, there are going to be thousands (if not millions) of market participants going for the same price. 

In addition, automated black-box trading systems that can pick up any announcement in real-time before placing a trade in the appropriate direction and appropriate volume within milliseconds will always beat an individual trader trying to work out what the announcement actually was, what effect it is likely to have on the market price and then scrambling to place a trade with a secondary counterparty, on a retail trading platform. 

Yet despite this fact, most retail traders will look forward to non-farm payrolls above any other market factor simply because it tends to print the largest candle on a chart. Some would argue this is just pure greed with a fair share of naivety thrown in.

Most retail traders begin trading without being fully conscious of the huge gap in awareness, information and experience that exists between them and the larger market players such as banks and hedge funds – it is a truly David v Goliath encounter and yet novice traders rarely realise this, do not take sufficient steps to address the gap and as a result, are mostly unsuccessful.

The key to success for any individual trader is to become and stay informed – not only with regard to how market forces work but also the logistics behind any trading environment. Self-awareness, strong discipline and realistic expectations are probably three of the most overlooked aspects of trading in the retail trading community. Large institutions and experienced market professionals have their own weaknesses too so it’s all-important to have a simple, clear trading strategy which plays to your strengths rather than exposing your weaknesses.

Large institutions have weaknesses too and understanding how they operate is the key to exploiting them. Institutions usually have large order books to manage which means any trading decision they make will take time to implement - similar to an oil tanker attempting to change direction whereas retail traders could be compared to a small seaplane that can change direction very quickly or get off the water altogether if need be. 

The best bet for retail traders is to use simple money management techniques and focus on their own actions as a priority. In other words, concentrating only on the things they can control. Trading is a battle of buyers and sellers which often spurs comparisons to some form of a gladiatorial battle between retail traders (David) and institutions (Goliath) but the core truth is that the battle is solely with your own self rather than a one-on-one battle with another trader. 

The FX market is a huge liquidity pool where both small and large traders can be successful at the same time. The most crucial David v Goliath battle is internal whereby you’re fighting against your own greed and fear on a particular trade – a tough battle indeed but one that can be won by focusing on the logistics of carrying out your trading plan and not the profit/loss that may result.

Commissioned by Forex Club
Written by George Tchetvertakov