My Best Idea for Small Investors

Stocks are a wonderful investment but they will not be the right choice for small investors looking at trading for a living. A widely cited figure is that stocks return about 10 percent a year in the long run. If a successful trader can triple that, a 30 percent annual return will not amount to a significant annual salary on a small account. That represents a profit of $3,000 on a $10,000 account and many traders will start with less than $10,000. Assuming that 30 percent gains were steady, it would take about 8 years to reach $100,000 and an annual income of $30,000 with all profits reinvested for the first 8 years. Starting with a smaller amount would require even more time to grow a $100,000 trading account. There is also no guarantee that 30 percent returns could be achieved and the odds are that returns would be sharply lower.

To make big money, or just to make enough to earn a living, a small investor must use leverage. Foreign exchange is usually thought of as a high leverage investment. It is not suitable for all investors because it is a fast moving market and requires a large commitment of time. Another reality small investors must face is that time is a limited commodity and they will be working at a full-time job which limits the time available for trading. Ideally, a forex trader will be glued to their charts and this is incompatible with a full-time job. Dedicating a few hours in the evening to trading could be productive some nights, but other nights the markets won’t move during that exact time. In the end, there can be no assurance that the trader will make money consistently.

My best idea for small investors is to turn to the futures markets. Commodities have been the source of some of the most legendary trading fortunes, like that of George Soros. They offer a high degree of leverage and risks can be managed to avoid catastrophic losses. This market offers the best chance for a small trader to make a living trading quickly.

The next question small investors need to face is how to trade. A disciplined approach with objective criteria is usually best for beginners.

There is a seemingly easy approach that is not likely to work. Charts are visually appealing and seem to offer clear cut signals, but that clarity is really only available in text book examples. In the real world, in real time, even experienced analysts will disagree on how to interpret charts. There is also a tendency to interpret the charts in a way that validates the trader’s bias – bullish traders spot patterns that tell them to buy and bears see sell signals in every chart. With so much discretion, success ultimately comes down to luck.

While technical analysis is usually associated with charts, there is more to the discipline that. Technical analysis also includes a number of indicators that can be applied in a consistent manner to maximize the chances of winning. Traditional indicators apply different mathematical techniques to price – adding, subtracting, multiplying and dividing prices in a variety of ways to generate signals. All have their advantages and disadvantages, and all require time to understand. Given the assumption that time is a limited commodity for small traders, this means that new traders often try to apply indicators without understanding them. As with chart reading, this is an unlikely path to success.

Realizing that indicators are simply reinterpreting price data, we can cut out the middleman so to speak and use nothing except price in a trading strategy. The advantage of this idea is that we will minimize the tools required to trade. Closing prices can be tracked in a spreadsheet and signals generated without needing specialized software.

My best idea for small investors is to use a simple strategy. Buy when price reaches a new four week high. Sell and enter a short position when price sets a new four week low. This is a strategy known as the four-week trading rule.

With forex, traders can start with a very small account and that is appealing to many small traders. Some futures contracts offer low margins and are suitable for small traders. A general commodities index, the CRB Index, has a margin of only $400 at some brokers. It is a very good trending market and profitable with that simple four-week trading rule. The chart below shows winning and losing trades with winners marked by green boxes and red boxes signifying losses. Since the beginning of 2000, the system has averaged about one trade a year. It is always in the market long or short, winning about 80 percent of the time. On a single contract, it offers an average annual return of about 20 percent a year. As profits mount, you can use the gains to add contracts and build equity faster. It is a great futures contract with a low margin and is an excellent way for new traders to learn the markets and build a larger trading account.

Margins in Fed Funds futures are about $500 per contract. These contracts have very low volatility and they are also a great starting point for new traders. Another example of the trading strategy applied to Fed Funds futures is shown below.

Treasuries are also low margin contracts with strong trending characteristics. As additional capital accrues in the account, or for traders starting with higher initial balances, the Brazilian Real, US Dollar Index and sugar are contracts with strong back test results using the four-week rule.

New traders should avoid complexity and stick with the simplest methods as they learn the markets. The four-week rule is a strategy that has been written about since the 1970s and it has withstood the test of time as a winning trading plan.

Traders need realistic expectations, and this is especially true for small and inexperienced traders. Small account balances will yield small dollar amounts in the stock market but can be leveraged for superior returns in forex or the futures markets. Of the two, trading futures is more likely to deliver steady returns for the part-time trader.

My best idea for the small trader is to apply the four-week rule in futures markets with low margins. You should add additional markets as your account size grows, and it is very possible to be trading for a living fairly quickly.

By Michael J. Carr, CMT