How do proprietary traders come up with trades?

I was hoping someone could explain this to me. I understand how say, a hedge fund comes up with its ideas, a long-short fund does fundamental research and comes up with a potential trade. But how do prop-traders do this? My perception of a prop-trading is that they're doing hundreds of trades each day, almost like a day-trader. I understand that certain prop shops are liquidity providers and they make markets so I can understand how they make their trades but what about other firms that make directional trades?

Are they trading based of technical analysis? That seems to be the focus of every trading book I've ever read. Also how can they remain consistently profitable? How can they make directional trades so frequently and be right all the time? I apologize if this is a stupid quesiton but it seems kind of impossible to me, all these prop shops or prop-deks at banks are essentially trading against each other aren't they? How can they all be consistently profitable if their game is zero-sum?

 
Best Response

They aren't right anywhere close to all the time aside from pure arbitrages. If you're right even 50.1% of the time and have low enough costs and do a lot of trades, you'll make money. If you run enough trades like that, it makes sense statistically that you'd make money almost every day. A lot of directional trades are based on statistical models. What people put in them is akin to their "secret sauce" so you probably will have to figure that out on your own. It could be anything from events in the order book, news, technicals, how other instruments are trading, etc. There's no set way to build this type of model which is what makes trading fun. If you can think of a good idea that nobody else has, you can make a lot of money.

Trading as a whole is zero-sum, but there are people in the market who aren't trading on short-term opportunities, and are either too slow or don't care enough to pay attention to them. Prop traders make money off these people either through picking off their badly priced orders or making a market to them and getting edge via spread.

Also given firms may be consistently profitable, but you have to realize they pay a lot in costs to do research and build infrastructure. Some firms fail as businesses even if they make money trading since their cost of doing business eats up all their profits. When you look at something like Virtu's s-1, what you're seeing is survivorship bias. There are dozens of firms that have failed for every one like that.

 

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