Comparing Stocks 101

Comparing Stocks 101

Proprietary Trading 101

Proprietary trading, often just “prop” trading, occurs whenever a person or company trades its own capital on its own behalf. The objective is plain and simple- to generate as much profit as possible. Traditionally, this was done by banks and other institutions to add revenue to their loan and investment banking income. Recently, with the increase in internet-based trading, the tables have turned and prop trading has become very popular amongst the private sector. As more and more individual investors have taken up trading, investment firms have begun to offer capital for use by individuals in exchange for a portion of trading profits.

Leverage

The primary advantage that proprietary traders have over retail investors is their access to leverage. In a traditional investment account, an online account with Scottrade.com for example, the maximum leverage one can achieve is 2:1. In contrast, proprietary traders are often allowed leverage up to 50:1. This means that an account with $2,000 is able to purchase (or short) $100,000 worth of stock in a proprietary account compared to only $4,000 in an ordinary retail brokerage account. Oftentimes this leverage comes “hassle free” meaning without margin calls or carryover fees.

Commissions

Proprietary trading accounts have a unique fee structure that differs significantly from online brokerage accounts. Traditional online brokerage accounts charge commissions on a per transaction basis. This means that there is a flat rate charged to each transaction, regardless of the number of shares, usually between $10 and $20. Proprietary accounts, on the other hand, mostly operate on a per share basis. This means that commissions are assessed based on the number of shares traded, regardless of the number of individual transactions, usually in the neighborhood of $.004 to $.01 per share.

Consider the following graphic that compares the two commission structures:

Commission, Average cost, 100 share round trip, 100 trade/12,000 share day - Online brokerage account er transaction $15, $30, $300 – Proprietary trader account er share $.075, $1.50, $90 plus Profit Sharing of up to 90%

One unique feature of proprietary trading accounts is profit sharing. Profit sharing in proprietary accounts occurs between the firm providing capital and the trader using the capital as buying power. Firms do not just give traders large sums of money for free; profit sharing is one of the ways that traders pay for access to capital. Profit sharing often begins at 50/50 and decreases (the trader keeps more of his or her profits) over time. No need to worry, take home profit rates in the 95% to 100% range are readily obtainable at most firms. The rate of profit sharing is dependent on a number of factors, the most influential of these being the number of shares traded. The more shares a trader trades in any given period of time the lower the profit sharing percentage.

For example, trader A trades 200,000 shares a month and shares profits in a 85/15 split while trader B trades 1,000,000 shares a month and shares profits in a 100/0 split. This occurs because more income is generated by the firm on commissions and thus they allow the trader to keep more, or in some cases such as this, all of their profits. Some proprietary trading firms allow traders to negotiate their profit sharing amount, perhaps exchanging higher commissions per share for a greater take home percentage. At the end of the day firms want to attract and retain top talent; trading fees and profit sharing will become more favorable as you become a better, more profitable trader.

Software, Data, and Other Fees

Every business has expenses that it must make in order to stay in business. In the case of proprietary trading, these expenses take the form of software, data, and other fees that are associated with remaining connected to the financial world at a professional level. The most common, and usually the largest of these, are software fees. Proprietary trading requires high performance computer software to tap into equity and derivative markets in the fastest, most accurate way possible. Sophisticated software such as Sterling Trader, LightSpeed, and TradeStation is somewhat expensive; however it is an absolutely necessity to serious proprietary traders. Software is offered in two pricing plans- month to month and lifetime. Paying monthly for software is more common, and runs anywhere from as little as $50 to as much as $600 a month. Lifetime purchase is less common as they require a large upfront cost, often several thousand dollars, and lock you in to one software program that you may or may not like over time.

When it comes to proprietary trading, data fees take several forms. The most elementary of these is a high speed Internet connection. Although cable and DSL connections are sufficient, higher bandwidth connections such as T3 and fiber optic lines are much more reliable, and give you an edge when it comes to data and execution speed. The next expense to be considered is the exchange data itself. Real time exchange data is extremely important, relatively inexpensive, and often comes at a nominal fee added on top of the cost of your software.

In addition to software and data fees, there are a few other expenses that many traders incur. Website and news source memberships are the most common. An example of this would be a Bloomberg terminal subscription. This subscription goes above and beyond web content to offer professional traders with up to the second information on virtually every financial market. Another example would be a real time audio news service, or “squawk box”. Squawk boxes are offered by a few different providers however they all do essentially the same thing. A reporter stands on the floor of the various exchanges and reports real time news alerts over the Internet. Squawk boxes give online traders an insight to what’s happening on the floor at any given moment.

Who Opens Proprietary Accounts?

Proprietary accounts are not for everybody. An investor who intends to make a few trades a month in a buy-and-hold style will have little value added through a proprietary account. Most commonly, prop accounts are opened up by individuals looking for access enough capital to take their trading to a professional level. Prop accounts are the primary account type among professional day traders as they provide traders with the buying power needed to make meaningful profits on a daily basis.

Consider a prop trader with a $5,000 balance. If this trader is allotted 50:1 buying power he or she can purchase $250,000 worth of stock at any given time. If this trader is able to extract a modest.25% profit per day on a consistent basis he or she will earn $625 a day. That might not sound like much, but that $625 a day translates to $12,000 to $13,000 a month or just about $150,000 a year. Not a bad return on a $5,000 investment.

There are a number of things to consider before applying to a proprietary trading firm. If you’ve determined that you are serious about becoming a full time professional trader the next step is to find a proprietary trading firm and apply for a desk position.

Make sure you consider the following items when looking for a prop firm: