According to a famous study by UC Berkeley’s Terry Odean, amateur investors are 3.2% worse at picking assets to trade than a chimpanzee is at throwing darts. Given such a high failure rate, most people who pursue a career trading forex eventually give up altogether. Be that as it may, there are still people who enjoy longevity within the forex marketplace.
There is a possibility of making a profit from the forex market, and many philosophies have been birthed in the pursuit of that objective. Discretionary accounts are one of those philosophies.
What is a discretionary account: all you need to know
A discretionary account is a type of investment account that authorizes a trader to make trading decisions without consulting their client for consent on each trade. To effect this arrangement, the client will typically sign a discretionary disclosure with the trader, which is a document that gives the trader unfettered control over their client’s forex trades.
Since these accounts need to be actively run by the trader, they often charge higher fees than other forex trading accounts. The typical fee is 1-2% annually of assets under management. Additionally, most brokerage firms will require a minimum investment for a client to qualify for this service. The usual minimum is $250,000.
How discretionary accounts work: technicals, fundamentals, and more
Most trading strategies involve generating signals based on mathematical formulas, price action patterns, or fundamental analysis. However, discretionary traders incorporate all these analysis forms to develop their trading processes, combined with their intuition gathered from years of market experience trading forex. This experience grants them flexibility and adaptability to changes in market conditions.
However, some clients may not be comfortable with letting their broker fully take the reins of their forex account. In such a case, the client may put down certain limitations for the broker/trader in the form of instructions or constraints on how they want their assets traded.
Recently, these accounts have embraced robo-advisers, autonomous investment management programs that utilize algorithms to identify investment opportunities. These robo-advisers utilize strategies that embody Harry Markowitz’s modern portfolio theory (MPT). They also allow for user-generated parameters, which could limit them only to apply particular investment strategies.
As opposed to their predecessors, these robo-advised accounts have much lower requirements for starting account balances. Some even allow a $1 starting balance. They also charge significantly lower fees, typically 0.25% per annum or less.
Advantages
For one, these accounts enable faster trade selection and execution. In the forex market, major price changes can happen quickly, giving the trader a limited timeframe to enter or exit a trade. If the trader has to run each trade by their client first, they would be forced to enter trades at less opportune prices, sometimes even losing the trading opportunity altogether. These accounts enable the trader to act as a sole entity, allowing them to capitalize instantly on a potential trading opportunity.
In addition, discretionary traders often manage multiple accounts of different clients. It would be tedious and time-wasting to inform each client of a potential trading opportunity before acting on it. Furthermore, the clients at the bottom of such a trader’s list would be entering or exiting the trade at a much less desirable price. With a discretionary account, the trader could enter all their clients’ trades collectively. That way, all their clients get in on the trade at the same price.
These accounts also allow the trader to adjust their trading strategies on the go. In the highly dynamic forex market, possibilities are infinite. Other traders may lack the capability to adjust their trading strategies to match the prevailing market conditions. Consequently, they may suffer huge losses when the market changes and their trading approach is rendered obsolete. However, since discretionary traders operate on instinct, they can notice changes in the market and adjust their trading strategies as warranted by the current market conditions.
Drawbacks
A major pitfall of this type of trading is the emotional attachment a trader can develop to their trading decisions. Since the trader’s intuition is the basis for making trading decisions, such a trader’s confidence in their decisions is vital to their success.
When the market fluctuates and the trader’s accounts undergo significant devaluation, it could falter the trader’s confidence and cause them to second guess their decisions. On the other hand, if the trader undergoes a prolonged period of continuous success, they may become overconfident and get reckless in their decision-making. Either way, the application of their trading strategies will likely suffer.
Another disadvantage is that this type of trading is prone to human error since it involves hands-on placement and management of trades. In today’s forex market, since price changes occur in a matter of minutes and seconds, these traders often have to execute multiple trades in a very short timeframe. This can introduce slippage and increased human errors.
These accounts have also been performing poorly over the years. A study by Asset Risk Consultants (Arc) in 2015 realized that roughly 50% of asset portfolios under these accounts had failed in the markets, generating negative returns. Further, only 20% turned a profit, while the remaining 30% were classified as neutral.
Summary
A discretionary account is characterized by clients who give brokers the liberty to trade on their behalf and to make trading decisions. However, these clients can customize their accounts by stipulating limitations, such as highlighting the investing strategies the broker is allowed to employ. Recently, robo-advisers have been inculcated into these accounts to minimize human interference.
These accounts have advantages such as faster trade execution and flexibility of trading strategies to match prevailing market trends and conditions. On the other hand, their drawbacks include increased risk of human error, traders being prone to emotional trading, and substandard performance as observed in recent years.
