Michael Halls-Moore invited a reply to one of my tweets last week, “Retail traders have an advantage over the pros? Me thinks not.” He wrote a great overview of why the institutional traders look longingly at the retail crowd and all the hoops that they don’t have to jump through.
His points are all valid, but he overlooked the big picture. Pricing is everything to a trader. Retail traders get the short end of the stick when it comes to the cost of doing business.
The cost of trading is massively disproportionate
Let’s say that you’re a would be quantitative trader and that you’re looking for opportunities. Let’s say you trade mini lots in the forex market with 60% accuracy and 1:1 risk reward ratios. If you’re not familiar with what a typical trading system looks like, those numbers means that you have an enormous edge.
Some of the less reputable forex brokers out there charge 3 pip fixed spreads. If you’re trading with a broker offering fixed spreads, I urge you to start price shopping. Fixed spreads are wildly overrated. You pay a huge premium for the certainty of a fixed spread. I can’t think of anything remotely plausible to justify them.
The larger forex brokers charge typical spreads in the neighborhood of 2 pips on the largest majors. Although most seem to find this reasonable, the comparison between a 2 pip average spread and institutional spreads is night and day.
Do you know what the average EURUSD spread looks like on the interbank market? It’s often 0.2-0.5 pips. Retail traders pay an average markup of over 300% on their trades.
Retail forex prices have declined in recent years. A few brokers like MB Trading and Pepperstone offer raw spreads with commissions tied to the dollar volume traded. These are, in my opinion, are about the fairest prices available to low balance traders running an expert advisor.
The best deal available to semi-institutional forex traders (CTAs, large balance retail traders, etc) is Interactive Brokers. The customer support is famously poor; they’re cheap for a reason. IB also offers raw spreads with a commission.
My experience with IB has been excellent, but you need to trade size for the economics to work. A 0.5 pip typical spread is great, but the 2 mini-lot minimum trade size and $2.50 minimum commission really adds up. Trading with IB doesn’t approach institutional type pricing until your average trade size approaches 1 standard lot.
So, how does pricing affect the final outcome with our 1:1 risk reward strategy that wins 60%?
- Free trading: After 100 trades, you’ve earned $600 and lost $400. The hypothetical net profit is $200.
- Fixed spread: You’ve spent $300 in spread costs to enter 100 trades. The total net profit is -$100 ($200-$300).
- Average retail: You’ve spent $200. There is no profit because you breakeven ($200 hypothetical profit – $200 in costs). However, your broker loves you for doing that many trades.
- Good retail pricing: Let’s say the average cost of a trade is 1.3 pips after commissions. You’ve spent ~$130 placing 100 trades. The total profit is $70.
Even with good strategies, the profitability of your algorithm is as simple as choosing the cheapest broker.
Trading stocks is even more expensive than forex. I remember back in the day when I thought Scottrade was cheap for offering $7 commissions. It gets worse and worse when you go through the list of stock brokers. Most of them try to get away with charging $7-10 per trade. If customer service is important to you, then those are the shops to look at.
If your top priority is trading profitably, then again, broker selection is critical. The only way that a small guy can make it is by chipping away at the costs. Interactive brokers is again a great option, charging fractions of a penny per share traded. If you decide to trade 2 shares of Google (GOOG: $1,017 per share) or 1,000 shares of Fannie Mae (FNMA: $2.35 per share), the transaction costs are tiny. Two ticks in your favor is all it takes to cover the trade.
You might be thinking that I said two ticks in forex is expensive. How can I say that two ticks in equities is reasonable?
Volatility. Two ticks in the stock market is a little hiccup. It’s not at all uncommon to see highly liquid stocks move 2-3% in a single day. Forex is only interesting because of the leverage. The currency pairs themselves rarely move more than 1%, and that’s usually on major news.
Every employee knows that they’re only one mistake away from getting fired. That’s the reason that everyone hates having a boss. There’s a single person with unilateral authority to financially murder you. Who’s going to look upon that as a good thing?
Well, the truth is that bosses exist for a reason. It’s someone that calls you out when you do something stupid. More importantly, the boss has the power and influence to ensure that you stop doing stupid things.
The dream of entrepreneurship is not having a boss. You go on vacation when you can, you don’t have to play office politics, you don’t have to waste time selling good ideas. You just go out and do them.
Even with good strategies, the profitability of your algorithm is as simple as choosing the cheapest broker
I can tell you as a small business owner that the negatives stand out strongly in my mind. When you don’t have someone to hold you accountable, even if it’s a mentor, you make many more dumb mistakes than you should. It takes incredible discipline to hold the line consistently. Knowing that I’m not going to look stupid or have to explain myself to anyone probably gives me a lot more false confidence than I really need.
Self-employed traders working at home experience the same thing. Who calls you out when you’re trading just because you’re bored?
The decline in the trading account points out the obvious, but that’s not enough to necessarily stop the bad behavior. We’re social creatures. Most people need to speak with other people to maintain their sanity. When you’re trading at home alone, it takes a lot of effort to ensure that you’re getting enough social contact. A good boss prevents you from indulging in bad behaviors.
Selecting the right broker is enough to determine whether or not a good strategy will wind up making money or not. It’s expensive to trade. The bigger you are, the better your pricing.
Retail trading prices have reached a point where it’s at least possible to trade profitably. Nonetheless, the number of strategy types out there is limited because the lower, shorter term strategies are prohibitively expensive to trade.
The quantitative traders and hedge funds get the more active strategy space to themselves. Their trading costs are so low that they’re really the only people that can afford to trade actively.