Principal vs. Prop Trading

Thanks for the information. Are you saying that regular flow traders who don't take short term positions are agency traders, so pretty much every flow trader in an illiquid market is on a principal trading desk then because they are almost always forced to take short term positions. Because I read a description of a group, and it said:

"a proprietary principalling/investing desk that pursues opportunities across unique and noncorrelated risk classes."

:confused:

a principal group generally trades with the bank's money (i.e. you are the principal ... there is no agent) ... a prop desk may trade with the bank's money, but may also trade with funds from outside investors... (you may be both the principal or an investing agent)

i wouldn't consider either one to be big on flow trading (providing liquidity to other participants int he market).

There are groups called Goldman Sachs Principal Strategies and Goldman Sachs Principal Commodities which both imply that principal = prop, but I've never been too quite sure about the difference

Sherminator- Flow traders that are acting as an agent are not taking positions. The group you are describing is definitely a prop desk.

oldhat- a principal transaction when your taking the other side of a trade for a client is considered flow trading.

Redbull- The goldman group you are referring to is a prop desk.

Unfortunately the term principal can be easily minconstrued hopefully that cleared it up.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

so if a principal transaction is one in which the trader is taking the opposite position for a client, why would the client want his broker taking the other side in the first place?

because definitions overlap ever so slightly and people use the phrases interchangeably.

Technically speaking, a proprietary trader's primary purpose (99%) is to seek profit potential for the firms account INDEPENDENTLY of the commission/spread based trading that defines the flow and main focus of principal traders (75+%). That is, their profits and positions are driven by the success of proprietary trade ideas/models and NOT by arbitrage and re-positioning around client driven trade execution.

Most trading positions found on the sell side - aka the principal trader - also take some proprietary risk though, except that it is commonly referred to as "principal risk". This refers to the direct market exposure the firm's account takes by being on the other side of a transaction with a client (unlike an agency transaction where the firm takes no risk and only charges the client a fee for its services). The amount of proprietary/principal risk on a principal trading desk varies by firm and product. The bulk of principal trading always involves transactions with clients and the earning of spread/commission, but rarely in my experience is a desk perfectly hedged (ie, it normally has some risk exposure, like choosing to stay long after buying assets from a client) and often some desks take outright positions in products because they have views based on their information flow (customer, volume, research). I would say my desk is 85% principal 15% proprietary trading.

The reason I think these two main trading roles get confused is that clearly in both types of trading the firm has exposure to PnL. The difference is that in proprietary trading it is the purpose of the business (you have an idea, you risk the firms capital on it), and also, prop desks often trade multiple products. Vs principal trading, where exposure is a primarily a byproduct of the business (you can't take the other side of a clients trades to earn a spread w/o having exposure - however temporarily) but is also an option for the business (trader liking the market and choosing to be net long his product) -- with this later part being very much like prop trading, except limited to the specific product expertise of the trader.

Hope that helps.

Excellent response winton. I have a question for you, you said that your desk is 85% principle and 15% proprietary. When you say this do you mean that most of the time traders are acting as principal but able to take on proprietary positions when they see something they like develop?

Or do you mean that 85% of the traders on the desk do principal and the remaining 15% is pure prop trading?

Finally a question on principal trading, what happens when the client is right on the direction, ie, market is tanking and they are selling into it forcing you to be a buyer into a falling market? What do you do in that situation because if you cant unload your position or immediately hedge it your left with what i call spoiled meat (a trade in th red). Im assuming your in some kind of fixed income desk or OTC market. This is probably the area outside learning better fundamental analysis that interests me the most.

PM is ok.

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

I meant what you said initially, "most of the time traders are acting as principal but able to take on proprietary positions"

As to the client being on the right side of the trade, its complicated - your response depends on the situation, but it is always delicate with respect to the relationship. Off the top of my head....in the instance you describe where the market is clearly falling, your bid will obviously reflect that, though you still have to show a price in the "context of the market" (ie if the market price fell to 97, you cant be at 80, without disrespecting the relationship or damaging the franchise - then again maybe its just a shtty client, so you dont need to care and can give them a sht bid...but still not an outrageous one) and perhaps the client will not wish to sell anymore. You could widen your bid/ask spread to reflect the increased risk in trading the asset and better cover turnover costs. You could set up a riskless trade if you know a buyer (real money sometimes just buys independent of markets) of the product to match against the seller. You could overhedge the asset on the expectation of further price depreciation (dont worry about not being able to hedge, you can always do this in some form). You could convince the client this isnt the right time to unload the product if you have valid reasons or better replacements. You could try to step in and offer your expertise to work the client out of the asset as an agent (ie, no risk). Then again, the purchase of the asset might actually flatten out your net position, in which case there's no immediate need for you to do anything after....etc

This is a good question, because theres a myriad of things you can do, there is no 100% right answer (though clearly there are wrong ones), and answers might be different depending on what you trade and how the market is doing. Though sometimes you've just been fcked or the client got lucky and as we say in the biz, "it is what it is". In which case you take your lumps, move on or be weary of the counterparty if you're finding yourself frequently on the other side of their shtty trades!

"(dont worry about not being able to hedge, you can always do this in some form)"

Not true - there are many illiquid markets where it's near impossible to get a decent hedge.

Also, you can just tell the client that you're not positioned to give a price. This may not be acceptable in some markets, but it happens in less liquid ones.

I was speaking to the question put to me of not being able to hedge AT ALL, but I meant what I said. A good trader can always find a hedge, even in illiquid markets. Take GS and subprime for instance - you think just maybe that was an unconventional hedge? And did I not say "in some form" qualifying that it may not be perfect (which is impossible anyway)? Do you think the majority of people reading these boards will be trading in "the many illiquid markets" you think you're referring to? And ah, last time I checked, "near impossible" does not equate to never, which would mean in actuality you agree with me.

And did you even read my last paragraph where I note the complexity of the question, or did you just skim this whole thread and cling on to one thing so you could have something to post about for "+1 banana points"? Where are your original thoughts, huh? Seriously, avoid responding where intelligent people are talking unless you can add real value to the conversation.

To recap: wintonheights 1, Ficcster 0. This game is over ladies and gentleman. Goodnight.

""(dont worry about not being able to hedge, you can always do this in some form)"

Not true - there are many illiquid markets where it's near impossible to get a decent hedge.

Also, you can just tell the client that you're not positioned to give a price. This may not be acceptable in some markets, but it happens in less liquid ones. "

absolutely true. had another dealer refuse to quote something this morning.

For the fairness of this thread to prevent confusion when illustrating your points please tell what type product you are referring to. Different products obviously will have different conventions, at this point im not really sure what I want to trade but im fairly sure what i DONT want to trade

"Oh - the ladies ever tell you that you look like a fucking optical illusion?"

As to giving marketers decent prices, and/or caring about their relationships, all i have to say is:

I eat breakfast three hundred yards away from four thousand hedge funds who are trained to pick me off. So don't think for one second that you can come down here, flash a client relationship, and make me nervous. Son, we live in a world that has risks, and those risks have to be hedged by men like me. Who's gonna do it? You? The Sales Force? I have a greater responsibility than you can possibly fathom. You weep for your client and curse the desk. You have that luxury. You have the luxury of not knowing what I know: that your client's loss, while tragic, probably saved p&l. And that my existence, while grotesque and incomprehensible to you, saves p&l. You don't want the truth - because deep down, in places you don't talk about at parties, you want me in those screens. You need me in those screens.

We use words like roll-down, carry, gamma. We use these words as the backbone of a life spent defending something.

You use them as a punch line. I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very bonus pool that I provide, and then questions the manner in which I provide it! I'd rather you just said "thank you" and went on your way. Otherwise, I'd suggest you pick up a prop book and stand a post. Either way, I don't give a damn what you think you are entitled to!

Haha that's a good one Jimbo!

"I was speaking to the question put to me of not being able to hedge AT ALL, but I meant what I said. A good trader can always find a hedge, even in illiquid markets. Take GS and subprime for instance - you think just maybe that was an unconventional hedge? And did I not say "in some form" qualifying that it may not be perfect (which is impossible anyway)? Do you think the majority of people reading these boards will be trading in "the many illiquid markets" you think you're referring to? And ah, last time I checked, "near impossible" does not equate to never, which would mean in actuality you agree with me."

Firstly, why would people on the board not be trading in illiquid markets? You think we're all on 50k per bp like you?

Exactly i said near impossible - in some markets the only time you can get a hedge is when sales can find another client willing to take the other side. You said "you can always do it in some form" - wrong.

Please explain to me how you would hedge JPY inflation vol in size?

And your reference to GS subprime just demonstrates your lack of understanding - the guys who put those trades on made a lot of money when the markets tanked; you think that was a hedge? By definition if you're hedged you don't make/lose money whatever happens... The guys had a strong view, put on some trades in size, and made a killing.

how would you hedge a synthetic CDO?? any ideas?

Jimbo - im very surprised (and confused) by your agreement and statement concerning the last part of Ficcsters post (which i hadnt commented on - yet). especially since i thot you traded a liquid product (rates?) and were on the sell side?? that certainly seems exactly opposite now. perhaps i misread something...

anyway, i think there are FEW trading instances where just telling a client "i don't have a bid" is generally acceptable. note key word CLIENT. in fact, its just bad business. and thats why i didnt recommend it earlier. its not something i would teach people trying to learn trading. if on the other hand, you came to me as another dealer looking for a bid, i wouldnt think twice telling you to p*ss off if the trade wasnt in my best interest. that sounds like the sitchy youre describing, jimbo. if so, not the same thing.

I realize that in the current market where liquidity has been scarce for low volume products or those out the credit spectrum trading has become unconventional (and I alluded to this in my first response) - where you can tell a client i dont have a bid (and even then only for some seriously illiquid prods) but unless were going to trade like this for the next decade (in which case were all fkd) then you need to think about your trading business and not just the value of your book for the next few days. And for full disclosure, when I speak Im generally talking about FI rates/credit/corps/structured trading.

The other post by jimbo was a monk-e-mail (from careerbuilder) that was pretty popular around the street early last year (which makes me realize ficcster is a newbie or gasp, not even in the biz) if i find the link ill put it up - its even better through the website.

anyway...were straying from the original questions of this post. Effectively, what i added where ways to tell a client no w/o telling a client no and other ways to protect yourself if you have to do the trade. and if you really trade direct w/ large institutions, thats the way the game works. when BROC/PIMCO calls you don't just say no unless you dont want their business anymore (or your GS, who always gets away w/ screwing their clients!). i put what i thot was appropriate. anybody have anything else valuable? beuller? beuller?

ill "learn" you some things because I think other people will benefit. and b/c i ripped you a new one earlier (im a trader, im volatile, shrug), ill be easier on you this go around...

fist though - when did i ever say people would not be trading in illiquid markets? (shakes head). second - you're agreeing with me that hedging is possible again! (shakes head)

anyway...to respond to the rest of your statement. if you're relying on salesmen to find a hedge to the other side of risk that you might be long at any moment, im not sure you can call yourself a trader. ive never heard of such a thing. what do you execute trades for a real money a/c or something? perhaps you can enlighten everyone on what exactly it is you "trade" and give some clear examples? b/c now im just plain curious. and i do not claim to know everything, but im gonna go out on a limb here and solidly claim that yours is not a is not a defining market or a majority interest and thus not great for a general response about hedging. Asking about japanese inflation volatility, seriously, just proves my point.

which way do you want the rest? in the business when you actually sit behind a desk every day, a hedge is not only the act of protecting completely against the downside of an asset you are long, it is also commonly used to refer to the instrument. For example one can be long tsys as an asset or be short tsys has a hedge (a la the context referred to in my GS "hedge" comment earlier). Got it? Also, hedging a position in the real world has variety - you can have an even hedge (the text book style you referred to), but it can also be net positive (underhedged) or net negative (overhedged) position. Got it? Ok, now to tie it all together - GS made a lot of that 07 coin in subprime by shorting a ton of an index well over their long position in the asset (all over the news??)...so even if you really want to insist on getting into semantics, shorting (or being net short in this instance) is very much right inline w/ the concept of hedging (it only categorical that you be long an asset first).

i have nothing else to say to you. we're through here.

I'm speaking out of my element...but Im pretty sure two frequent hedging instruments used for that asset class is the ABX index (referenced to a portfolio of ABS backed bonds) and a CDX index (referenced to a portfolio of investment grade entity credit).

"Jimbo - im very surprised (and confused) by your agreement and statement concerning the last part of Ficcsters post (which i hadnt commented on - yet). especially since i thot you traded a liquid product (rates?) and were on the sell side?? that certainly seems exactly opposite now. perhaps i misread something..."

i do trade rates, but not the vanilla stuff. am frequently left with very imperfect hedges.

As for the custie stuff, depends on the client and how important they are to a business. you will take lousy trades if you think you can make money in other ways or going forward. if they are just in business to pick you off, we will show terrible prices, or no prices on the monstrously illiquid things i often get asked to price.

"The other post by jimbo was a monk-e-mail (from careerbuilder)"

Actually I got it from the author long before it went global. Love to dig it up from time to time it's one of my favorites.

"I'm speaking out of my element...but Im pretty sure two frequent hedging instruments used for that asset class is the ABX index (referenced to a portfolio of ABS backed bonds) and a CDX index (referenced to a portfolio of investment grade entity credit)."

I know guys who have gotten absolutely smoked using these two....

what product do you trade winton?

what I trade to a level I think is appropriate for this board and my comments.

Jimbo, your clarification does make more sense to me now...and your comments about handling a client seem to echo what Ive said previously. And the question was never about perfect hedging. I dont disagree w/ not being able to hedge an asset perfectly and indeed I mentioned its very text-bookish. Even if you found "the perfect hedge" in theory, correlation changes over time and can get significantly displaced in the short run.

And I cant dispute that "guys have gotten smoked" using those hedges if thats what youre looking for me to do...ABX trades very technically and IG10 has been particularly volatile. I do know guys that have done well using them however. Regardless, they're both still instruments commonly used for hedging those positions. Correlations have broken down on what were thought to be much more clear cut asset/hedge relationships as of late if thats what youre getting at. Do you have additions, alternatives? Or perhaps, Im on edge and I misread read your intentions.

As to the monk-e-mail? More power to you for having seen it before it made the rounds on the street. I mentioned it not as a jab against you, but for other purposes.