How Do These Guys Make Money?

Hi,

I am a retired mutual fund manager that is looking for a flexible job to keep busy. It has been over 5 years since I left and I truly miss the market now. I really want to trade my own account, but can't since my wife has a senior job with a WallStreet firm and they heavily restrict both our accounts. A friend has told me that I should consider a Prop Trading firm as a solution. I looked at a few websites and I have one question.

Here is the question. How are these firms making money? I am suspicious of anyone with brains who hands out capital to pretty much anyone who applies and makes it through the training period (markets are so random that some WILL succeed no matter what). And why are they continually recruiting people?

Based on my years on the trading floors of two major investment banks, I noticed that on Wall Street: 1) Firms do not like to day trade unless it is in the context of market making for their sales force. The reason is that intraday trading is quite random...without an information advantage.
2) They NEVER use their own capital unless it is pretty much a sure thing (arbitrage, legal insider info, etc).
3) Their proprietary trading departments try to have as few traders as possible. They find a few guys who can trade, and then they allocate their capital to them.

The small prop firms out there seem to be doing the opposite of all three. There must be some other way they are making money.

Before I even call one of these firms up, I just want to know.
Can any vets out there tell answer my question?

 

most of the time, the first risk they take is on the capital the trader brought to be accepted in the program

Thanks,

Sarah

 

There's two business models you will generally see. One is where the trader puts up his own capital and trades his own account. He is usually responsible for 100% of his losses and keeps all his gains. The firm provides leverage greater than retail and makes it's money on commissions and interest on leveraged overnight positions. It's basically a glorified retail account.

In the other model the firm will let the trader trade for close to it's cost of transactions and make money on a profit split with the trader. The trader may or may not put up any of his own money. They can take on inexperienced people and throw them into the market with minuscule risk parameters. They either start to produce and get a bigger line to work with or they are let go. The firm risks very little but makes it all up from the guys who turn out to be good.

Contrary to what you've been taught on the street, daytrading can be a profitable business, it's just much harder to do at the scale a large wall street firm would need to operate at. Like in any business you are going to find great firms and the slime balls. You just have to do you due diligence.

 

Even a retired mutual fund manager can't answer these questions, who else can?

 

Thanks very much, lescor, sarah.
Model One I can understand totally and the same for Sarah’s refinement.

Model Two seems to make sense also, especially if they engineer the stops on the unsuccessful traders to prevent their losses from eroding the gain earned from successful traders. But still, the question I have is that after a while, they should know who their successful traders are and they should stop recruiting at that point.
Their focus on recruiting and having many branches nationwide, suggests to me that somehow, they are making money off transactions. But that should be impossible under Model Two. Any comments from anyone?

Sorry if I sound overly suspicious. Maybe prop firms are truly out there looking for people who can day trade. Again, I just want to know.

Lescor:
Point well taken about day trading. My comment was only from the perspective of the Wall Street department heads who has a lot of other options in how they can make money. I am just assuming that the guys who are capitalizing these prop firms have similar options.

So no offence to day traders out there. Although I was never allowed to day trade (even for my own account), I have watched the market all day, everyday from 1994 to 2004, and I can see how a nimble, truly disciplined individual could possibly succeed.

Thanks.

 

What if there are no guys capitalizing the prop firms, and that the capitalization is rather from the client traders (not all traders use their maximum margins and/or not at the same time)? (like a banking model).

In addition a new client can be a potential client to other financial institutions. To give you an idea of the potential, a click in google costs in the order of $2. Assuming that 2% of the visitors would give their information, the cost of one signup is $100. Therefore, 10 partnerships can already lead to $1000 per new lead in a hypothetical prop firm. The numbers in relation to the ad costs are realistic because I own some sites, and I have an idea of the stats/costs/etc.

 

I read the book "after the trade is made", or some similar title, that discussed how money is made by brokerage firms.

It would be useful if you could discuss some of the other options available to wall street heads to make money.

 

Commissions and interest on margin balances would be my guess. I don't think that they're doing anything particularly nefarious or unique. They're basically prime brokerage for the masses.

I have also been in the profession and I agree with your points about what the firms do. I think a lot of people misunderstand what wall street does which is basically market making. The smart money isn't at the banks, it's at the speculators, ie. hedge funds and the banks' clients. The banks are the casino that make a spread, the hedge funds are the ones who create new strategies that make more money than frictional/slippage costs.

This is good for the average joe because it means that they too can make hedge fund returns if they have the talent and time.


A lot of the prop firms in Chicago came out of the exchanges. The sole prop locals have been around for a while. With markets turning electronic and edge shrinking a lot of firms moved upstairs or shut down. When the 'local' shuts down and lays off a bunch of guys, they look for a way to keep trading. They're left with work for another local/firm or take their money to a prime broker. Some guys can't pool the million or whatever for the JBO accounts so companies like the prop shops you find are filling in the need for capital.

That is the main draw for me, capital.

 

Perhaps this will help:

Most of the "prop" firms take in capital contributions from the trader. The minimums vary, but the least I have seen is around 3k, most are 5k, and some are around 10k-20k. Although the prop firm gives buying power, the trader takes ALL THE RISK of loss, as any losing trades are cut from the original capital contribution. Whereas the prop firm will make money on the markup of commissions, and those who have a profit split make an override on any gains. If the prop firm implements proper risk parameters, which they often do, then the firm cannot lose. Of course, it's only beneficial if the firm takes in winning traders, but they must continually recruit people if traders continually blow up their capital contributions.

"TRANSACTIONS" generate commissions, and commissions drive the market, as another post stated on a different thread, "it's written in the scrolls."

There are a very few firms (equity props) that will hire a trader on a base salary, offer training without charge, and then allow the trader to use firm capital without making a capital contribution. These firms want fresh college grads with limited or no trading experience. So that would not apply to your situation.

 

Hi,

A little off-topic but I’ll give you my answer (similar to the other poster’s answer).

Flow. They make money off the flow of money that passes through their firm and they do it in many different ways.

1. Lending collateralized money (especially on margin accounts) is #1. If a client has $1,000,000 of stock in his margin account, and wants to put it up as collateral for a $1,000,000 loan, a brokerage firm will do that all day long. It doesn’t even cost them anything. They go to a bank, put up the customers stock as collateral and then pass the loan onto the client. The best part is that the rate they charge the customer is HUGE compared to the low rate banks offer from collateralized loans. The even better part is that they will now make commissions based on $2,000,000 not $1,000,000. I still remember the feeling of beauty/admiration I got when this was explained to me during my training well over 15 years ago.
2. Commissions – No risk for the firm. Recall Eddie Murphy’s reaction to his training in ‘Trading Places’: “Yeah, I undastand, you boys is bookies’.
3. Nickel and diming on account fees. They add up.
4. Market Making is huge. Making money of the spread from orders made by your sales force is huge and almost riskless.
5. Arbitrage. These firms are uniquely positioned to reap profits from mispriced securities. Again, there is no risk: true arbitrage involves a long/short that results in a positive cash flow for the trader “up front”.
6. Structured products. I don’t think Ferrari or Lamborghini would have made it past 1985 if it wasn’t for the demand created by the amount of money made in structured products!! If I could do my career over again, I would gladly trade the prestige and decent income of fund manager for the chance to price and sell a product that few of your customer knew/how to value.
7. Cross selling products.
8. The ‘carry-trade’. Borrow short term and lend long term. As long as the yield curve is positive and there are no blow ups (actually occasional blow ups are ok as long as you don’t leave the bonuses you earn in the form of company stock).
9. Correspondence. This is a NY term. I don’t know the term used by the public. Here the brokerage firm offers to clear trades and act as custodian for a tiny broker somewhere in middle America for a set-fee.
10. Trading off legal insider information. It is hard for someone who has never sat beside a market maker on a busy trading floor to understand the huge information advantage that these guys have. An example may illustrate, if stock XYZ releases a piece of bad news, we the general public, have to decide how to react (i.e. Is the news priced in already? Will it cause a move? If so, how much?). Not institutional traders managing an inventory, they don’t need to guess or analyze! They know who is holding lots of XYZ and who is short lots of XYZ. Most importantly, if he is at a mid-sized firm, the reaction of his clients will represent a reasonable sample of how the entire market will react. So, if after the news, the sales starts berating him orders to get rid of the stock, he knows enough to offer a crappy bid back to his sales force so he will be able to offset the XYZ he takes in once the clients hits the bid. Beautiful isn’t it? The best part is this: at a decent sized firm, the clients his sales force has attracted will represent a decent sample of the entire market. The way his sample reacts to the news will be decent indicator of how the entire market will react, so he can adjust his inventory accordingly. THAT IS TRADING WITH AN ADVANTAGE.

Also, I have heard that there are myriad of ways to make sliver of change during some steps of the clearing process. I never worked in the backoffice, so I am not an authority on this. I’ll check the library for that book.

That’s enough for a holiday morning. Notice how all of the above do not involve the firm risking large amounts of their capital –only just enough to keep the flow moving. Also, notice how the return is guaranteed or at least a known probability? All of the market professionals I have met had that in common, they don’t use their own capital unless they have a clear advantage, and if they don’t have an advantage then they will still trade…..but only with someone else’s money for a fee. I would think that the people running these Model B prop firms (such as SwiftTrade) would have a similar mentality (I think that is what I was trying to say in my previous post).

But maybe not. I looked at some of their backgrounds of senior people at these firms on linkedin.com and none so far had industry experience….most were sales people or had some mid-level bank position far from the markets.

Mr. TradingJournal, I think you have a great grasp on how the Model A prop firms work (the ones that require a deposit and simply provide leverage). I figured their model out right away.

But I need help understanding Model B (the one where no deposit is required). Are they really repeating the classic original TurtleTrader social experiment on a grand scale, or are they running a sneaky variation of Model A?

Kind Regards,
CrazedSOB