Institutional Trading & Retail Trading

by William Naranjo on May 8th, 2022

What is Institutional Trading?

You’ve almost certainly heard about institutional trading. For example, consider an IPO in which only institutional investors were allowed to buy shares. If you’re still unsure what this form of investing includes, I’ll explain what it is and how it differs from retail trading in this post.

Institutional trading | Definition

What is the definition of institutional trading? The buying and sale of financial assets by institutions through their dealers is known as institutional trading. This definition of institutional trading encompasses all types of institutional trading, including institutional equity, institutional stock, and institutional options trading.

Institutional trading is carried out by major corporations with teams separated into analysts and operators, with the former focusing on technical and fundamental analysis and the latter studying the data and implementing the methods and operations that they deem most appropriate.

To do this, institutional trading includes vast sums of money, allowing dealers to diversify their investments and avoid large losses.

Furthermore, because they deal in huge volumes, institutional traders have access to higher market prices and can even directly affect the price movement of the assets they trade. In truth, institutional traders are engaged in a battle to gain control of the market and steer it in their favor. Institutional trading has a significant impact on stock prices.

How did they gain such power? They enter long if they believe a market will rise, just like any retail trader would, but they can influence the confirmation of that trend by entering with significant quantities of capital.

Consider the following scenario…

George Soros vs British Pound

A well-known incident in the financial sector occurred in 1992, and it provides a vivid picture of how institutional Forex trading can influence the market. To set the scene, in the midst of the recession in 1990, the British government opted to join the ERM (Currency Rate Process), a mechanism through which some European countries set a fixed exchange rate based on the German mark.

Shortly after, the German government was forced to hike interest rates to control inflation as part of the reunification process, and the rest of the European Union countries were required to do the same. The Bank of England was under a lot of pressure at the time, and it only had two choices: devalue its currency or exit the common monetary system.

So, how did George Soros react at the time? He had anticipated this move and had taken a $1 billion short position against the British pound, which he expanded on September 15–16. The Bank of England tried to counteract this tendency by acquiring 1 billion pounds, but the move was barely noted on the market, so it chose to raise interest rates from 10% to 15%, a desperate effort that also failed. Just hours after raising rates, the Bank of England announced its exit from the ERM.

The pound sank 15% on that day, September 16, 1992, and Soros profited almost a billion dollars. That day became known as ‘Black Wednesday,’ and it was the day that Soros rose to prominence in the world of institutional trading.

Types of institutional trading

In general, there are four different types of institutional trading. These are the details:

Hedge funds

Hedge funds are ones in which the managers have complete autonomy. That is, they have complete control over the assets in which they invest, which is why they are also known as free management. They can then use intricate techniques involving derivative instruments to try to maximize possible profits in both bullish and negative circumstances.

Hedging methods, as the name implies, are frequently used by these funds, which buy and sell associated instruments at the same time. Arbitrage tactics are also quite common among them.

Because substantial quantities of cash are required to access these funds, their clients are companies, pension funds, or investment funds. That is, as we will see later, their clients work in institutional trading. Hedge funds provide larger profits, but they also come with increased risks and expenses.

Mutual or investment fund managers

Mutual or investment funds pool resources from a variety of participants, both individual and institutional, to invest in a variety of assets organized into investment portfolios. The key benefit is that you can access a wider selection of assets at better prices. A corporation will be in charge of managing investment portfolios that have been pre-designed in the mutual fund contract, therefore it will not have the same level of freedom as hedge fund managers.

These funds have the advantage of being simple vehicles that offer diversification while adhering to professional criteria. Furthermore, investing in them does not require a big amount of capital, making them accessible to retail traders. This means that retail traders can now participate in institutional trading.

Pension fund managers

Pension funds are similar to investment funds, except that they manage money from their clients’ pension contributions in order to provide returns. These funds, which can be used to fund one or more pension plans, are overseen by an institution that decides where, how, and when to invest. The institutional trading sector includes these funds.

Investment banks

Investment banks are financial intermediaries that provide advice services and sometimes function as brokers in market-related transactions such as initial public offerings (IPOs), subscriptions, mergers, and reorganizations. JP Morgan Chase and Morgan Stanley are two examples of investment banks. These are also included in the institutional trading category.

What is Retail Trading?

Retail traders often invest in stocks, bonds, options, and futures, with little or no access to initial public offerings (IPOs). The majority of trades are performed in round lots (100 shares), however retail traders can exchange any number of shares.

If retail traders use a broker that charges a flat fee per trade in addition to marketing and distribution expenditures, the cost of making trades may be higher. The quantity of shares exchanged by retail traders is frequently insufficient to have an impact on the security’s price.

Retail traders, unlike institutional traders, are more inclined to invest in small-cap companies since they have lower price points, allowing them to buy a diverse portfolio of assets in an acceptable number of shares.

Special Considerations

Despite the fact that retail and institutional traders are two different types of dealers, retail traders frequently become institutional traders. A retail trader may begin by trading for their own account, and if they succeed, they may expand to trading for friends and family.

If a retail trader generates positive returns and attracts additional funds from other investors, they may form what amounts to a tiny investment fund. This exponential rise can continue indefinitely until the retail trader becomes an institutional trader.

Institutional Trading vs Retail Trading — Differences

Although you may have already observed the distinctions between institutional and retail trading, we’ll go over them again below for clarification:

• Buying and selling assets through a personal or individual account is known as retail trading. Institutional trading is similar to retail trading in that it involves purchasing and selling assets for institutional or corporate accounts.
• Although retail traders now have access to financial instruments that were previously only available to institutional traders, some choices remain out of reach, such as initial public offerings (IPOs) and some futures contracts that are only available to large investors.
• When it comes to commissions and prices, institutional trading outperforms retail trading when dealing with higher sums of cash.

KEY TAKEAWAYS

• An institutional investor is a company or organization that trades securities in large enough quantities to qualify for preferential treatment from brokerages and lower fees.
• A retail investor is an individual or non-professional investor who buys and sells securities through brokerage firms or retirement accounts like 401(k)s.
• Institutional investors do not use their own money, but rather, they invest the money of others on their behalf.
• Retail investors are investing for themselves, often in brokerage or retirement accounts.
• The differences between institutional and retail investors relate to costs, investment opportunities, and access to investment insight and research.

One last important point

Before you leave. I want to mention that there are major different trading strategies that retail traders & Institutional traders use. In the next article, I will go in-depth about this. Stay tuned!

by William Naranjo on May 8th, 2022