Prop Trading Structure

7toaster:

The incentive for having a prop shop is that there's a lot of regulation that applies to hedge funds (to protect investors) that don't apply to prop firms. Prop shops do much of the same stuff as hedge funds, but they're allowed to be much more secretive about everything they do.

Also, I cannot parse this question: "Are all prop trading groups broker/dealers where partners commit equity capital and the broker dealer is able to using revolving margin lines to provide its trader's with trading capital." Could you rephrase or explain what you mean in this question?

Thanks 7toaster. That question is with regards to the funding. Do they take accredit investor funds and pool it together and provide that capital to traders. Or is the equity capital typically provided by the managing partners and the trading group's broker dealer allows them to lever that equity capital to use on a intra-day and overnight basis?

abcasdf:

Ok since I'm bored to death, here is my Easter 2 cents to yall this fine Monday (and please no PMs):

It is somewhat inaccurate to say that prop trading firms and hedge funds do similar strategies. Hedge fund strategies tend to range from long/short equity, distressed investing, global macro, and then your quant hedge funds. Most prop trading firms focus on low draw down, very high sharpe ratio quant/arbitrage strategies. You do have prop firms like FNYS which are a little less quant than others but for the most part, prop trading firms look for pure quantitative edge before they put on trades. Prop trading firms tend to focus on high frequency trading, stat arb, options market making and there are some hedge funds such as citadel that have internal prop trading arms with no external client money.

The reason why prop trading firms operate differently is predominantly b/c their strategies don't require much capital b/c of prime brokerage (PB) structure and they prefer to keep their returns rather than give 80% of it to clients. You'll see that most of the time, quant trading hedge funds keep a bigger % of their profits as well such as DE Shaw and Renaissance (before they shut out external capital) Lastly, prop trading firm strategies are limited in scalability compared to let's say a long/short or global macro portfolio where you can have +30 billion and actually deploy it efficiently. Here I'll give you an example (don't try this at home): if I'm long 100 million S&P futures and short 100 million of S&P 500 stock basket that I sold at a small .05% premium, my PB sees my risk and for this trade, we'll put up let's say 10 million, my PB will put up the rest to cover this on margin and my firm will charge me capital usage (risk free rate/opportunity cost of capital) and my PB will charge me interest on their capital and short stock fees on the stock and this will be charged against my P&L until I unwind the trade for using this capital. You can see why you do not need a lot of capital for these type of strategies.

Lastly, why are traders at prop trading firms compensated so well? Well that's because traders in most hedge funds (long/short, global macro) tend to be execution/risk managers for stock analysts/economists. Say an analyst wants to get long Citigroup; the trader at this long/short shop would work with the analyst to figure out how to put on this trade. Should you buy the stock, buy calls, long call ladder, etc and should you short another financial or maybe S&P to hedge out systematic risk? They do not originate the trading strategy but optimize it. At banks, the trader's function varies depending on which desk you trade on and what type of trader you are. If you're simply executing client orders, you don't deserve to be paid well period. Traders who take on principal risk (disguised as market making nowadays post Volcker) at banks tend to be paid better but they often have a lot of overhead such as quant/strategists who help them build models and figure out strategy, controllers, mid office, and sales people who get them clients to pick off =) Traders at banks have to share their profits with sales people, quants/strategists, and even the investment bankers once in a while if the relationship originated there. Prop trading shops tend to run very lean (overhead wise) and they come up with their own strategies, execute them, and manage them so they get to keep a bigger % of their profits. Also, expectations are pretty high at a prop trading shop and the first 1-2 years is a test/paying dues to see if you're good enough to trade there and even after the intense filtering done at interviews, a lot of prop traders are let go if they can't keep up.

Thanks abcasdf for the info. Question remains, what motivates the founders of the prop trading shops. Assuming its a shop where the firm provides capital (the trader doesn't have to put in a deposit) what motivates the founders to put in the equity capital. Trader's could potentially lose their money but if they don't then they end up keeping only 20%-50% of profits. In short, what's the incentive for the prop trading firm's founders?