The biggest players in the markets are banks, institutional investors and hedge funds. They hire the best staff, provide the best training and use sophisticated algorithms and computer-aided analysis.
If these entities are the competition, why is it possible for a smaller trader to beat the market and make money with day trading?
Institutions and banks make inefficient trades
The financial markets have evolved to facilitate the exchange of goods, currencies and other assets for practical purposes and so a large number of trades do not happen to directly make a profit with them.
To give an example, the foreign exchange market evolved because different countries needed to trade goods and services, while the futures market developed because of a need for price stability in the fluctuating commodities market.
Participants in this type of trading are not concerned with getting the best possible price, thus, making the trade they do inefficient.
A large number of trades in the market are for purely practical reasons and therefore inefficient, allowing traders to take advantage of this inefficient trading.
Exchanging money while travelling is trading
Consider the very simple example of exchanging money when visiting a foreign country. If someone goes on holidays to a country with a different currency, they will very often use a local exchange shop to exchange currency– this is trading in its most primitive form.
These shops often offer bad exchange rates; yet, most people do not care and exchange their money at inflated rates anyway. They simply want to enjoy their holiday and need to conveniently acquire local currency to do so – and this allows the exchange shop to be a very profitable business due to the fact that their customers do not care what exchange rate they get.
This kind of trading does not simply take place in the given scenario – entities, such as corporations and banks, all take part in trading for practical reasons – buying materials from another country for instance. The amounts traded can be substantial and as such, move the market price, creating opportunities for speculative traders to make a profit.
Consider the following examples of inefficiencies in trading:
Trading as part of the “real economy”
In the foreign exchange market, trading is a requirement for doing business.
A trader with their own account is not bound to the necessity of doing business and so is able to take advantage of movements in the exchange rate as it best suits them.
For example, if a company in Europe purchases products from the United States, they will have to exchange euros into dollars to do so. When many companies are exchanging huge amounts of currency, then the demand for the US dollar, on this scale, changes the exchange rate.
These companies are not concerned about potential profit, or whether analysis shows that a trade is likely to make sense at the time. They have to exchange currency to do business and so they will.
A trader with their own account is not bound to the necessity of doing business and so is able to take advantage of these movements as it best suits them.
Trades made for corporate reasons
There are many cases where trades are made for corporate reasons. For example, if a manager of an investment fund hears some negative rumours about a certain company, they might have to sell the stock that their fund owns. Even if they think the rumours are most likely untrue, if there is a slight chance they could be and they fail to take action, they could lose their job.
A trader acting on their own account can be free of those conflicts of interest.
Trades made for political reasons
An independent trader can seek trading opportunities during times of economic turmoil, because price fluctuations are likely to happen, causing the markets to move significantly.
In times of economic turmoil, bond yields and other markets, such as the stock and currency markets, become unstable. Investors also seek safe havens in currencies, such as the Japanese yen or the Swiss franc, causing further price fluctuations, making some countries too expensive to do business with. Central banks or state-run entities buy assets in order to stabilise these markets causing the prices in these markets to move significantly.
An independent trader can seek opportunities at these interventions.
Trades made for emotional reasons
When news and reports trigger emotional responses, the markets and news enter into a vicious circle that can result in erratic trading and high volatility in the markets.
News and reports often trigger irrational and emotional responses by traders that change the overall market sentiment and move the price significantly. This market sentiment then gets reported by the media and triggers further emotional trading, which in turn triggers more news coverage by the media – the markets and news enter into a vicious circle that can result in erratic trading and high volatility in the markets.
A trader can take advantage of this and wait for the right opportunities to profit.
Speculative trades
Due to the above, traders can create substantial profits by exploiting inefficiencies in the markets that are created when trading takes place with reasons other than profit in mind. Thus, a lot of trades in the financial markets are made for speculative reasons, so a trader will not only seek to exploit market inefficiencies but will also compete against other speculative traders who are all out to make profits. In essence, speculative traders also trade against each other.
As a result of that, if one trader is able to anticipate or predict how other speculative traders will act in specific circumstances, they can benefit from it by incorporating this knowledge into their trading strategy. Very often, this principle plays a role in technical analysis, where a trader follows certain indicators, not because a trader fundamentally beliefs in them, but rather because of an assumption that all other speculative traders take them into account when trading. Thus, a speculative trader cannot only make money by exploiting inefficient trades, but also by being one step ahead of the competition.
Size matters – the smaller your portfolio, the better the expected price of an asset.
We have seen above that there are multiple reasons why market participants will make trades which allow others to make a profit.
However, while this explains why trading can be profitable, it does not yet show how a small trader can compete with larger institutions. After all, these companies have the advantage of getting better prices, having large teams of well-trained people, as well as access to sophisticated analysis and computing power. As it turns out, while these advantages are genuine, the biggest disadvantages of these companies are the respective volumes that they have to trade.
This is because the inefficiencies in the market are limited in volume and are of different magnitude. Once that volume is used up – i.e. once the inefficient trades have cleared – the inefficiency disappears.
How does this manifest itself in practice?
Shares are often quoted at different prices; an entity selling shares will quote the price that they want for them. However, for each price level, there is only a limited number of shares for sale – once those are sold, and you want to buy further shares, you will need to do so at a higher price.
A bank or a fund often handles billions of dollars, which means these institutions can find it difficult to fill their order at the quoted prices. A trader that trades smaller positions is less likely to have this disadvantage.
If you are a small trader and see an opportunity in the market, it’s very unlikely that the volume you trade will wipe out these inefficiencies or even work against you. However, if you are a large institution handling significant sums, not only will the market inefficiencies often be too small to commit a significant share of your capital to it, but the volumes that you trade might actually move the market price which may cause you losses later on.
Consider the following example:
The table below illustrates how many shares are available at different prices for the same share. Say that an analysis shows that 20 euros is a great price and 21 euros would be considered too expensive.
The following table shows how the shares could be quoted at different prices and the availability of them at each price. Here, the prices are given in whole euro amounts – in reality, there would be many price levels in between.
| Price | Number of Shares (Offer at the Price) | Value of the Transaction |
| 20 | 1000 | 20,000 |
| 21 | 2000 | 42,000 |
| 22 | 500 | 11,000 |
| 23 | 4000 | 92,000 |
If you only wanted to buy 10,000 euros worth of shares, you would fill your order at 20 euros per share. You can see from the table that there are currently 20,000 euros worth of shares available at that price.
However, if you wanted to buy 100,000 euros worth of shares, then this is more than the current 20,000 euros worth at that price and you would have to purchase the shares at different values.
You would have to buy:
- 1,000 shares at 20 euros
- 2,000 shares at 21 euros,
- 500 shares at 22 euros and
- 1,174 shares at 23 euros
This gives an average price of 21.45 euros – according to the analysis, this price is too expensive.
Size matters in trading — if you have a small portfolio, it will be easier for you to exploit market inefficiencies and consequently get a better return on your trades.
The problem of being too big to trade profitably is very real – they have no chance of beating the markets.
Size matters in trading; if you have a small portfolio, it will be easier for you to exploit market inefficiencies and consequently get a better return on your trades. This will allow you to off-set the advantages enjoyed by institutional traders because they are faced with the challenge of finding profitable trades for portfolios of significant size.
Conclusion
We now know that a significant proportion of trades are made for reasons other than profit, and speculative traders can take advantage of this by exploiting these inefficiencies.
Also, speculative traders can take advantage of other speculative traders by anticipating their strategies and being one step ahead.
In addition to that, we have learned that, as a smaller trader, you can take advantage of trading smaller quantities, which means that you are more likely to secure the desired price.
Due to the above factors, it is possible to be a successful trader and beat the market. Of course, this requires a solid strategy, good money management and discipline.
Hung Trading 