Mount Everest Sunrise - picture from phobus@flickr (CC)

Being a small trader and “taking on” the big funds such as Winton Capital or Renaissance Technologies can seem as arduous as climbing the Everest. You might think: “What chance do I have to even come close to these guys and their army of PhDs? I might just send them a cheque to manage my money”.

Well, maybe it does not require rocket science to experience some success, as some simple mechanical strategies illustrate. Let’s examine the opportunities for the “small fish” trader.

The free lunch

If we consider traditional Trend Following, it pays to have deep pockets. Diversification is often referred to as “the only free lunch in finance”. The problem is that you need to have significant capital to be able to trade a wide array of futures, with possibly several different systems. This makes it hard to the small system trader to benefit from diversification.

The lunch is free only if you can spend big bucks on dinner!

New instruments on the block

However, a few new, and more accessible instruments have appeared in recent years.

Many ETFs and ETCs now exist for most markets now have their dedicated Exchange Traded Instrument. I have recently picked up a good book on the subject (A Practical Guide to ETF Trading Systems) and it does provide good ideas, especially on money management and how to increase returns without the leverage that can be found in the futures world (WARNING: I would not use leveraged ETFs for anything else than day-trading as they exhibit volatility decay).

The advent of spread betting (mostly in the UK) also allows retail traders to “bet” on financial markets with smaller starting positions than in futures trading but with similar leverage.

Finally, Forex trading has been made easier to access for retail traders, with new firms literally invading the scene in the last 10 years (OANDA even offers trading in any size starting at one dollar!).

Although not ideal, these new instruments help lower the barriers to entry and allow small traders to join the free lunch diversification party.

No footprints

Large funds have to deal with the extra complexity that their size entails. Their large orders and positions can weigh on the markets, impacting them negatively and forcing them to have dedicated efforts to execution algorithms development.

As a small trader, you are free from most of these constraints and can just get in and out of the market more easily. More importantly, this also gives you access to more markets.

Let’s check the monthly futures performance (with the new exciting tool from FinViz):

FinViz new futures tool showing some strong trends

Lumber had a particularly good month but given the size of this market, I doubt that any Trend Following Wizard significantly profited from that trend. Whereas, as a smaller trader, you could have.

Additionally I believe that these smaller, more exotic markets, exhibit less efficiency and therefore more opportunities to exploit them.

A big headstart: no fees

Even if you cannot match the performance of the large funds, the fact that you do not have to incur management/incentive fees when trading your own account is a big advantage. The difference can add up to a lot with compounding (deemed as “the most powerful force in the universe” by Albert Einstein some urban myth inventors).

No pressure

Another aspect that impedes fund managers “freedom” is the aversion of investors to drawdowns. However, reward is indissociable from risk and/or volatility. This means that managers will often tune down their strategy to offer a “less risky” but more appealing profile, at the expense of better returns. As an independent trader, you are free to decide your own tolerance level for risk and associated performance targets. You can be as aggressive as you want to be (for as long as the market keeps you alive ^_^).

a matter of personality

Finally, I believe it boils down to your personality. If you are an enterprising character, you will more likely be attracted to building and trading your own system. It might even be an irrational proposition, but I am sure some traders would prefer to invest a lot of time developing and then trading a system even if it achieved a slightly lower performance than the top Trend Following Wizards’ funds. But who said that trading in the markets was rational?…