Prop firm business model

Discussion in 'Prop Firms' started by elit, Oct 28, 2006.

  1. elit


    I would like to discuss propfirms in order to understand the business model.

    I am not aware of any companies of this type in my region, but still there seem to be an endless amount of prop firms around. So I would like to understand how they are doing business.

    Do the traders trade their own money or the companies' money?

    Why would a company hire in experienced traders in the first place? Or have I misunderstood it?

    Where do the companies get their profits? -Commissions? -Share of the traders profits? What if their traders lose money then?

    Is it lucrative? Does it require a very large amount of capital to start a prop firm?
  2. The main source of income is desk fees & commisions. As I understand it, it is similar to a casino. Spread over a large group of traders the P&L should even out and be posistive (if you hire good traders with proven track record). The commisions and desk fees make for a steady income stream.

    There is quite a large amount of capital needed as you need to be able to weather down months and have enough margin capital for multiple guys to be trading 100+ lots.
  3. lescor


    There are two main models.

    The first, more common in futures markets, is where the firm hires traders as employees and teaches them to trade. They trade the company's money at close to cost and the firm makes money by splitting profits with the traders.

    The second, which is how most equity prop firms are run, involves the trader putting up his own cash and trading his own account. The firm extends a lot of leverage to him. If the trader is good he can use that extra capital to make more money. Either way the firm wins because all their profit is on commission. They can also make money on things like monthly software fees and training courses.

    Either model requires a substantial amount of money to get a firm started.
  4. "Prop" business models vary somewhat. In the old days, a "prop" firm was primarily focused on hiring employees to engage in trading practices for the firm, do what the firm said, receive a basic compensation and perhaps a percentage of the profits generated. With the advances in technology and program trading, most of these firms replaced the "traders" with computers.

    On the exchange trading floors (historically) another business model took place (one which we at Bright Trading engage in), wherein an independent trader would buy a membership on the exchange (seat), place some money with a Clearing firm (who acted to clear trades and be the "bank"), and then the trader would essentially use the Clearing firm's money to trade with (most often more than a $million, often much more), and the trader would keep the profits from their own trading, and, of course, be responsible for any losses incurred. The Clearing firm would charge for this use of capital and services in the form of commissions and possible interest or risk fees.

    My brother and I bought memberships, placed money with SLK (now Goldmas Sachs), and pursued our trading careers. We were very fortunate and did quite well. We were able to negotiate with Clearing firm for lower fees by adding more traders, thus increasing the overall trading volume...making for "economies of scale". We formed BT in 1992 with 2 people, and by the mid to late nineties had hundreds of traders who essentially used our capital to trade, kept all their profits, and benefited from the same economies of scale. Since we had the "big" money put up with Goldman, we were (are) responsible for all the trading money and any possible losses.

    Now, our traders don't have to buy expensive memberships, and can enjoy the same benefits as exchange members, keep all their profits and use $millions of our money to trade with (with, obviously, some risk control).

    There are only a handful of broker dealer exchange member firms who engage in this practice these days. There are many "Introducing broker" type firms with little or no capital to protect the traders, and there a a few "sub-llc" type firms who are not broker dealers, thus offer little or no protection to their traders (be careful, as always, do the due diligence, check balance sheets, etc., as you would with any business partner).

    This model allows our traders to engage in trading strategies that actually work well, much like the strategies used by Lehman, Goldman, etc. (Pairs trading, market making, Mergers, and other simple, lower risk, higher reward, but capital intensive techniques).

    Just a quick overview, hope this helps, feel free to call with any additional questions (702.739.1393 mid trading day is usually good).

  5. elit


    Thanks for you replies!
  6. don what economy of scales are you giving me?the truth is don it cost's bright nothing to extend me massive leverage. sure you have to "put" up your money but i'm sure you're being paid a 5% or so money market rate on your money with few traders holding over night. and the ones who hold over night pay a nice fee. i laugh when i read all these people with different prop houses extending leverage like its a big deal. you're still making 5% on your cash balances and making huge money on overides. don to this day reading 10,000's of thousands of notes i can hardly remember more than a few traders who are with bright. and since i believe you're a very honest straight forward guy it has to be because of your very high commission rates. sure you provide some other services but when it comes down to it's the difference between paying .005 and .002 for traders doing 2,3 and 4 million shares a month is huge. . with the lack of volatilty the last few years commissions can be a very huge part of profit margins.
  7. darmasdt


    Dear Don,
    what is the timeframe/time horizone the traders use mostly in your company ?
    Are there traders who trade a long term trend-following system with your prop money ?
    Have you seen a consistently profitable intraday futures/forex trader in you company ?

    Thanks in advance. :)
  8. Brandon, you've been around a long time, and I respect you as's just that this is a rapidly changing game, and you see the fallout with even the biggest of Firms...we plan on being around a long time.

    "Few traders holding overnhight"? This is not 1995-1999 where everyone is "daytrading" - our traders keep massive positions in correlated pairs and mergers, not to mention conversions and core stock positions. With traders taking home hundreds of millions of $$ every night, we have to be very diligent with what we do. How in the world do you think we get 5% or whatever when the traders are using 50 or 100 times their capital in some cases.

    Economies of scale are not just from capital usage, although using capital is a big benefit to traders. Since FASB150 came into effect (essentially where firms cannot "use" their traders money as before, and must count the traders money as a liability), our group of "overnight capital users has grown considerably, mainly from other firms who "need" to use their traders money.

    Overall rates are very competitive, and with the growth we've seen from other firms (some big ones are going away as you well know), we know exactly what our overall costs are, and we have negotiated excellent "all in" rates. Sure, some may be cheaper at first glance, but when you factor in everything, many traders can be or/are better off here.

    All the best,

    Oh yeah, about the economies of scale question...LOL..oops. I was simply explaining the genesis of developing a trading business. It's obviously cheaper to align yourself with a solid broker dealer, avoid buying a membership, paying all the regulator fees, a Compliance Officer, front office and all the rest, that for a trader to do all that themselves...or else we would have hundreds of individuals with exchange memberships (as in the"good old days" when Bob and I first started).

    Now, all the best,

  9. lol love you don. i guess bright is different and that your guys hold the overnights were most prop firms its rare. again all the respect in the world for you as i really like you. i here your brothers a hell of a futures trader
  10. Maverick74


    Ok, I guess I have to issue a statement on behalf of all prop firms out there (including Bright Trading).

    There are numerous advantages to going prop.

    One is obviously the leverage. Both intraday and overnight. Now, I know a lot of you guys are saying so what. I can get leverage trading futures and FX at 100 to 1 right? Well, yes and no.

    The reason most guys want leverage is not to leverage straight directional positions but rather to leverage hedged positions or spread positions or complex derivative positions. I honest to god don't know that many leveraged directional traders, I really don't. So adding leverage to pure direction is really not a winning formula anyway.

    Another added component to leverage, or sub-component I should say, are risk based haircuts on derivative positions. This is what market makers on the floor receive. It can allow one to manage a pretty decent size book for position trading with minimal amount of capital.

    Another sub-component is the cross margin relief on similar products, especially beneficial for index or fixed income traders.

    Another benefit to the prop model is the ability to trade a wider range of products. Yes, I know IB offers a very extensive menu of products, but with many prop firms you can trade any product in the world, including emerging markets and pit traded contracts and still get leverage and cross margin relief.

    Another advantage is getting paid interest on credit balances in your account including short stock. Most retail brokers will not pay you the interest or the full interest on your money for example if you are short options or short stock.

    Another benefit are the tax advantages, i.e the 60/40 mixed straddle rule. This allows you to pay long term tax rates on 60% of your income and ordinary income tax rates on the other 40%.

    Another advantage is having access to an office to trade in with other traders and be in a professional environment.

    Then we have access to other means of execution i.e floor brokers. This is more important for those trading options markets and more illiquid products.

    Some firms also offer proprietary software that is only available for traders with that firm. Some firms spend millions of dollars developing this software.

    And lastly, we have the ability to get real capital, not just leverage. When you are involved with certain prop firms and in a professional environment, you are going to get access to some deep pockets. If you can develop a solid track record you can raise millions or even tens of millions of dollars setting up your own hedge fund.

    So obviously there are countless advantages to going prop. Like Don said, there are many different types of prop firms out there. But they all are very similar.
    #10     Oct 29, 2006