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More Retail Investors than Ever are Trading
Over the past few years, we've seen a massive influx of retail investors into the markets. The first half of 2021 set new records for account openings with over 10 million new accounts, more than the previous record year of 2020.
People were stuck at home, receiving stimulus checks, watching a market boosted by a decade of near zero-interest rates set by the Fed, and listening to promoters on TikTok, Reddit, YouTube and pushing a narrative of "stocks only go up!" got drawn in and began buying stocks and options on a variety of commission-free trading apps headlined by Robinhood.
Despite all the mania, too often the results look like this:
Imagine that being your retirement account or savings. Those kinds of losses may never be recoverable.
Why do so many retail investors lose money though?
One reason, they don't have a system.
Investors Should be Systematic
We believe that trading with a system - a set of rules that dictates your instruments, trade entry, exit, and risk - helps reduce your risk and thus chance of losing your account.
Nothing is foolproof - you can design a terrible system that takes too much risk or trades terribly, of course - but a system allows you to backtest your rules to give you a feel for its historical performance in a variety of market conditions.
That should help give you some confidence that you have a worthwhile strategy.
Beyond that, a trading system gives you three control over three key elements of profitable trading in the markets:
- Controls your risk
- Controls your emotion
- Controls your cost
We already alluded to it, but most traders take too much risk. A trading algorithm with your risk parameters pre-defined helps to make sure you don't put too much on each trade. It also gives you your exit conditions so you can get out of a trade without second guessing yourself.
As much as I like to think of myself as a cold, calculating engineer, I know that my emotions play a big role in my decision making, especially when it comes to money.
Without a system, if a trade goes against me, I want to see it come back. I hope it comes back. I wait for it to come back. All the while it moves against me and keeps losing money.
Left to my own devices, I do the opposite of the old trading adage, "cut your losses short and let your profits run" and my losses begin to pile up.
This is because I tend to see my stock picks and money management as a reflection on myself. Taking a loss feels bad because I lose money, but also because I was wrong, I made a mistake and am not as good at trading as I thought.
Putting this under a system, however, helps separate my emotions from my trading. I'm simply following a system that I expect is going to make me money in the long-run. I might get stopped out on occasion (maybe even most of the time) but I'm not tied to each trade the same way.
Low-cost ETFs and funds are low-cost, but that doesn't mean they're "no-cost." In fact, the hidden costs can be much higher than investors realize.
Everyone involved with Vanguard, Blackrock, and your brokerage has to get paid. Some estimates claim that these hidden fees come to 3-4% per year off the top of the money that you put into the account.
Think about that for a moment.
Your 10% year of passive returns winds up being 6-7% instead. Heaven forbid you lose money. A 2% down year becomes -5-6%!
Those hidden fees add up and occur whether the fund is performing or not.
Trading for yourself helps to keep this under control. At the very least, you can more clearly see your costs and work to keep those low. After all, nobody cares about your money more than you - especially when the big guys get paid for AUM, not performance.
How Average can Investors Compete
Earlier, we stated that most retail investors lose money in the markets. So why do we think that having a system is going to change things?
Apart from the three controls algorithmic trading gives you above, retail investors have some advantages over the big players.
Think about how much money would be meaningful to you, and I would guarantee it's less than Merrill Lynch is looking for. An illustration:
A few years back, I went to one of the higher ups in my company with an idea that would make us $10 million. I pitched the idea and was rejected as soon as I mentioned the amount. Why? Even with a healthy, double-digit ROI, the exec didn't care because it wasn't enough. If it was at least 10x that amount, he'd listen, but when I'm talking $10 million, that's a rounding error for a big company that's in the tens of billions annually.
As a smaller investor, you can get bigger returns and fly under the radar. You aren't moving markets. Your trades aren't being analyzed, so you aren't really competing with the big players like most make it out to be.
Another advantage you have is time.
Markets are moving faster as people are looking for shorter term turn arounds on their capital. Hedge funds and money managers provide monthly reports (and some are pressed to provide weekly reports) which pushes trades to be shorter and shorter term.
By slowing down, you can counter this trend and make healthier profits by being patient. Long term trend followers have noticed this as short term strategies have lost their edge, but longer term models are still profitable.
Finally, with more retail money flooding into the market, you'll stand out from all of the others by having a system and given some serious thought to your trading. That's at least worth considering.
Oh, and did we mention the importance of risk management?
How we Think About Risk
We're sounding like a broken record here: risk, risk, risk. But this is so key, it simply can't be stressed enough!
We like to break risk management down into 3 basic buckets:
- Position sizing
- Position management
- Exit strategy
This isn't a comprehensive list, but will do the vast majority of the work for protecting your account, and none of it has to be complicated.
Position sizing is simple: how much money are you putting into each trade? We can't stop you of course, but we aren't fans of YOLO bets where 90% of your capital is put into a single trade. That almost never ends well (go look at that loss porn image above again). Proper position sizing can be as simple as putting 1-2% into each trade. Or, you could optimize your allocation according to something like the Kelly Criterion, or set it according to a volatility metric like average true range (ATR). Whatever you do, keeping your trades manageable will help you sleep at night and keep your account intact.
Position management is what you do once you have a trade on. Do you add to it when it moves in your direction? Do you drawdown when it moves against you? What about when volatility increases or decreases? Again, you can be simple where you just rebalance back to a fixed 2% every few weeks or months - that's fine - or be complex and adjust positions based on correlations and vol. It's up to you.
Finally, when do you exit a position? The most common way to do this is via a stop loss where you sell when your trade has lost a certain percentage of money. This keeps you from staying in a trade and letting your losses run. You can change that to a trailing stop loss that moves up as your trade does, then sells when it retraces. Or you could just wait until your indicator reverses. Again, make it as simple or as complex as you want.
Whatever you do when you design your system, test it and make sure you follow your rules. Breaking your rules puts you back into the position of a discretionary trader and at the whims of your emotions and all that other stuff we wanted to get away from in the first place!
Starting Your Algorithmic Trading Journey
This is just the first entry in a brief series to get you from 0 to running a basic trading algorithm.
In the next installment, we'll be looking at building that first algorithm and provide you the code and an accompanying spread sheet so you can use it yourself.
Join our group on Slack and jump in the conversation! We're happy to help answer any questions and are excited to build a community of systematic traders!