Let's narrow the gap between pro and retail traders
Let's narrow the gap between pro and retail traders
And 5 tips to approach trading like a business
I knew a guy - let’s call him Jack - who killed it at the prop house I joined in London in the spring of 2011. A few months after I started, Jack decided to quit; he could do all of that on his own, he thought. A few months later, Jack reentered the floor - his confidence shattered, but happy to take his seat back. And although he started performing from day 1 again, he simply couldn’t make it as a retail trader.
These stories are legion.
Being a successful pro trader is no guarantee of success as a retail trader. Pros only realize all the advantages they had once they’ve left the trading floor.
Which ones, you ask?
A regular source of income to start with.
If you trade in a hedge fund, a bank, or a legitimate prop house, you receive a salary. This removes a huge amount of stress on your shoulders.
The first difference between a pro trader and a retail trader is so obvious, yet everyone misses it. A pro trader is an employee, and a retail trader is an entrepreneur. The latter is infinitely harder.
As an entrepreneur, you live, breathe, and dream about your business. Every single second, every single day.
Your mind races from payrolls to invoices and only takes a break to wonder how an economic downturn will impact you.
As an employee in a trading firm, you hate on your boss, that broken Excel spreadsheet, this broker you should befriend and why on earth that trade didn't turn out as expected.
But once you’ve left the office, you go on with your life. You have outsourced all the problems related to business management. Someone else is taking care of it; you are just an operator.
Your boss makes sure your strategy is in line with the firm’s philosophy. The risk department oversees your exposure; it must be compliant with the recommended guidelines. The research team keeps you on top of your game. You even have desk boys bringing you lunch so you can stay focused (at least we had some in my firm.)
All you have to do is make sure that vega exposure in the front month won’t get out of control and flatten your deltas before you join your friends/colleagues at the pub.
Even the extra work activities are an advantage - you get tips about a trade, a strategy, or a counterparty you should always welcome with a smile (Nomura - it was a pleasure doing business with you all these years.)
I was talking with
yesterday and he reminded me how much trading is a team sport. In fact, it takes a village to run a successful trading operation.And then you have the retail trader, alone in his room, six screens on flashing candle sticks, glued to discord forums and subreddits.
When you put it like this, no wonder 80% of them lose money.
Contrary to an employee at a firm, a retail trader is the only person accountable for the quality of their operation. No board (maybe your spouse?), no desk manager, no risk manager, no chief analyst, no quant, no nothing.
Contrary to the rest, successful retail traders are a bit schizophrenic - they are the CEOs of their own businesses and employees at the same time. That duality allows them to sustain and do whatever is in the best interest of their business.
Start your trading journey by holding you, as an employee, accountable for what you will do throughout the day, or else, within six months, odds say your account will be vaporized.
I write diligently this newsletter exactly for that reason. It is the equivalent of the 6.30 am meeting I had at the firm, where the research teams would present the big events for the day and talk about what was cheap and what was expensive. It set the tone for my day.
I’m more than happy to receive positive feedback about the value my content delivers. But selfishly, what it brings to my business is infinitely greater.
So, what can you do to narrow the gap with successful trading operations?
Here are 5 tips (and a bonus, we do it for the money, after all) that are easy to implement; they will greatly improve your PnL and your Sharpe ratio.
1/ Ditch technical analysis.
Yes, we all started there. Even my mom had books on technical analysis. It's the light in the dark, and without it, every retail trader is lost. But it’s time to grow up.
It’s not because you can dribble a basketball that you will win 6 NBA championships; unless you have an amazing intuition about the market (these guys exist), some patterns on a chart aren’t going to make you successful.
I have never seen pros making money with technical analysis except when they applied simple mathematical indicators to well-known trading methods. It usually implies mean reversion on pair trading or the variance risk premium.
What to do instead?
Try tools built by ex-traders for retail traders - Moontower is a great place to start. If you code, invest in APIs like Thetadata to get granular information about your market, or have a look at Sharpe Two’s own API.
2/ No, seriously, ditch technical analysis and invest in research.
I get it; you are addicted to it, and you have no idea what you would do with all that time on your hands.
Here is the second decision you will take as CEO - force yourself, the only employee of your firm, to consume x hours of research per day, as they must do on a real trading desk.
Get one step further - invest in some quality research. Yes, pay for it. What do you prefer? $500 lost in a stupid trade you can’t even explain, or $500 on articles that ultimately made you much more knowledgeable about the industry?
Like any investment, it compounds and pays dividends.
There is plenty of quality content, and Substack is changing the game completely - here are a few ideas for you:
, , , , , …You may even get in touch with the authors to understand their thesis better and extend your reach in the industry. Remember, it takes a village to be successful, and the quality of your network matters.
3/ What line of business are you in?
One problem with successful retail traders? The answer to this question is so ingrained in their psyche that they fail to ask it correctly to aspiring retail traders.
Instead, they go for the more generic “Where is your edge?” Great, but what does that mean?
Finding an edge is no different than focusing on a business niche and exploiting it rigorously. People need shoes - what does it take to be a successful shoe seller?
People need accessible groceries at any time - what does it take to have a successful corner shop?
In both cases, your biggest risks are a poorly managed inventory, buying items too expensive, and eating your profit margin. When you do it right, you sell overpriced items to people in urgent need for them - chewing gums, toilet paper, Doritos.
If you cannot articulate your value to the marketplace with a simple statement, it is hard to be profitable.
Mine? Every day, I sell short-term insurance contracts to fund managers anxious about their long-term performance.
Like any other business, selling insurance comes with some risks.
Would I sell an insurance contract without a granular understanding of the risks just to collect some premium? No, I consume a vast amount of research; I have invested in a significant data infrastructure in order to make informed decisions about what is cheap and what is expensive.
4/ Reduce your sizing by half.
Cash is the lifeline of any business. If you don’t manage it properly, you’ll soon be out of operation.
Let’s say you want to open a candy store to bring the ever-popular brand “Straddles” to your customers.
As a first-time business owner, do you start with one small shop, or do you spread yourself across 5 different locations and leverage every cent of your capital to capture as much market share as possible?
If the answer isn’t obvious to you, close your trading account right now and do something else.
90% of retail traders are overleveraged and would be much better off trading a 10th of their size.
I’ve seen first-hand the danger of leverage. It’s ugly. If you had to take only one thing from that newsletter, keep that one.
5/ Manage your deltas.
Managing your delta is the equivalent of staying neutral when exposed to your customer’s personal circumstances. Sure, you could trust Mark, about to go on a road trip to Vegas, when he swears he will be prudent, and give him a steep discount on his car insurance. But now, the soundness of this business decision relies on Mark’s self-control. Is that really wise?
When you keep an astronomical delta exposure, you let the market dictate your pnl. Sure, you may have an amazing view of the market direction, and this time, it’s different… Is that really wise?
I read one day that 80% of people making money on the retail side have super tight control of their deltas. It shows, once again, the schizophrenic nature of the most successful retail traders - acting as the risk manager, stopping the trader from taking a seemingly easy trade for the best interest of the firm.
A little bit of delta exposure is okay in a trading firm. How much? Mine was a 10th of our portfolio size for overnight exposure. For intraday, you needed some special authorization to be over 50% of your notional exposure. I still stick to these principles.
Bonus - keep your books in order. Everyday.
My first job ever was in a shoe store (If you haven’t read Shoe Dog by Phil Knight, by the way, you should. It’s a great way to level up your business game.)
A small one but a fairly successful one. Why? Because of ruthless bookkeeping by the owner, Mme Gimel, at the end of every single day.
Well, you are a small business owner, right? If you don't do your accounting, how can you anticipate what your cash reserve will be at the end of the month? And how can you know which product is your best seller and which one you should discontinue?
The quickest way to improve performance is by measuring it.
Measure your daily returns rigorously, and keep track of a 3 months rolling Sharpe ratio. Your performance will drastically improve.
Good luck.