Proprietary Trading Firms - A Different Business Model

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Prop Trading: Is It Legal?

There are no rules for how to become an independent prop trader. There are also no specific rules against it, nor any laws or regulations that govern the practice of independent prop trading. The only thing that matters is whether you're offering your services as a trader and making trades for clients. Jun 20, 2022


Proprietary Trading Desk Setup
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What do you mean by a proprietary trading firm?
Proprietary trading implies an individual, a group, a bank, a financial institution etc. trading with their own funds rather than trading on behalf of its clients, to earn profits for itself. Firms or financial institutions use the organization’s own capital to conduct financial transactions in various instruments, such as stocks, commodities, etc.

What are the benefits of being a proprietary trader?
Most of the investment banks have their own proprietary trading desks and so do many firms, financial institutions, banks, etc. Proprietary trading firms benefit in the following ways:

• 100% returns come to the proprietary trader
• A Proprietary trading firm can stock an inventory of securities for future
• Market making is possible

100% returns come to the proprietary trader
The main advantage of proprietary trading is that proprietary trading allows an institution to realize 100% of the returns earned from an investment, hence in the balance sheet of the company they are represented under investments.

On the other hand, when financial institutions trade on behalf of clients, they earn revenue in the form of fees and commission, which is generally a small percentage of the total amount invested or the gains generated. These earnings (from trading on clients’ behalf) are shown in the income statements of the company under commissions earned.

A Proprietary trading firm can stock an inventory of securities for future
Stocking the inventory of securities for the future is another huge advantage of proprietary trading. Since the proprietary traders use their own fund’s capital, they can stock the securities for selling them to their clients (of banks or financial institutions) later. Also, the securities can be loaned out to clients who wish to sell short.

Market making is possible
A proprietary trading firm provides liquidity to the market since it buys the securities and sells to investors at a future date.

When the interested investors buy those securities from the proprietary trading firm at a higher price than what the firm had paid for purchasing the securities, then only there is a profit to the firm. Hence, this way the liquidity gets infused in the market which is the main aim of market making strategy.


Prerequisites to setup a Proprietary Trading Desk
Educational requirements
To set up a proprietary trading firm, you need the knowledge in:

• Finance/Economics since proprietary trading firms are nothing but financial markets’ trading firms and hence, education or a sound knowledge in finance/economics is essential.
• Mathematics because the concepts of mathematics help to use statistical tools for historical market data analysis in trading. Historical market data analysis is quite imperative for predicting the market and for deciding the entry and exit positions.
• Business knowledge is also essential for proprietary trading since at the end of the day it is a business of trading in the financial markets.

Internship experiences
Having knowledge or education in financial trading related subjects is a great first step towards becoming a successful proprietary trader but that is not enough. Theoretical knowledge does not provide the necessary practical knowledge.

When you step into the financial market and begin trading, you get to know the actual challenges and finding the solutions with the right trading strategy is what makes you better.

Hence, becoming an intern with a trading firm can lead to drastic knowledge enhancement about historical market data analysis, strategy creation, back testing and live execution of trading strategies.

For both a student and a non-student beginner in the trading domain, learning algorithmic trading is optional. Although, the world has almost completely shifted to algorithmic trading including Wall Street.


Common steps for setting up a Proprietary Trading Desk

Registration
Once you are ready to begin setting up your proprietary desk, the first step is to register your firm/entity as a company or Limited Liability Company (LLC), Limited Liability Partnership (LLP), a partnership and even as an individual or proprietor. There are different formalities that you will be required to adhere to when registering the firm/entity.

Market access
Market access is nothing but finding your way to the financial markets in order to fetch the historical market data for data analysis as well as to execute the trade orders. In simple words, you need market access for entering and exiting the market to take favorable positions.

There are two ways to get market access and these are:

• Own membership
• Broker account

Own membership - Having your own membership in the financial market such as NSE or National Stock Exchange (for India) is beneficial. The benefits include having faster access, keeping the secrecy or the safety of order flow (for example, trading strategy) that can be sold otherwise by a broker plus there is capital efficiency with your own membership. Moreover, you can gain brokerage income from your clients with the membership. Although, there are certain things to arrange with your own membership such as compliance, capital for incurring costs etc.

Broker account - Having a brokerage account will undoubtedly not give you the benefits that your own membership gives. Still, there are certain advantages if you deal with the brokers that are well regulated and they are keeping the accounts segregated. Also, the broker’s background checks must be done properly. Brokers help you with all the compliance and you do not need to incur much cost either. Hence, your entire trading business remains in the broker's hands.

Arrange the capital
Since proprietary trading implies trading with your own money instead of with the raised money, you need to arrange the required capital for trading. It is as simple and as challenging as that!

Since you can not raise the capital unlike hedge funds, you will have to dig into your own pocket.

Get the essentials
Okay, now that you have the capital arranged, you will need to also invest in getting all the necessary equipment, knowledge, infrastructure etc. for your proprietary trading firm.

In case of manual trading, you mainly need a monitor for regular monitoring of markets. Whereas, for setting up an algorithmic trading desk, apart from a sound knowledge in algorithmic trading, you will need infrastructure, platform, risk management practice, back testing etc.

Regulation and compliance
Coming to regulation and compliance, it varies across geographies and trading destinations. Some of the exchanges need the trading system to pass through the conformance process, while some may need every automated strategy to be empaneled or approved.

Almost all the exchanges provide a test environment where you can develop and test your systems and strategies. As a member of the exchange, you would also need to comply with various statutory guidelines along with various mandatory audits as your respective regulator and/or the exchanges may prescribe.

Most of the regulated exchanges will also ask you to maintain audit logs, trade logs and incident monitors (to monitor crashes etc.). In most global exchanges, the trading members need to save the transaction logs for anywhere between 4 to 8 years, depending on the geography or jurisdiction.

Risk management
Risk management is the identification, assessment, and mitigation of risks. This will be followed by a coordinated and economical application of resources to minimize the impact of unfortunate events or to maximize the realization of opportunities. A risk management system (RMS) is installed within an algorithmic trading platform to manage and mitigate the risks of data access, consistency and quality of data, network protocols, and scalability factors.

Begin trading!
Yes, now you can begin trading using your very own Proprietary Trading Desk. All the best!


Conclusion
Proprietary trading is beneficial and simultaneously involves different levels of costs depending on the steps such as the educational background (initial steps), market access, capital arrangement (advanced steps) etc. This blog explored all the prospects essential to understanding how one can create and setup their very own Proprietary Trading Desk.

This covers the basics, initial steps and the steps for setting up a Proprietary Trading Desk, leading to beginning the trading process.

 

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One More Difference...

Last week, something happened that reinforced, in my mind, the practicality (pragmatism?) of using a business model where "prop desk traders" operate in accordance with signals provided by the firm rather than attempt to train or educate them to act independently…

Base on his written communications, I'd have to say that Ajay comes across as a pretty intelligent guy. Yet, a trade from the other day that SHOULD have had a positive outcome did not, because even though I specifically requested that he set expiry for 60 minutes from entry, he scheduled if for 15 minutes instead (which is what we had been using for all the previous trades/positions).

If even smart people like Ajay can be responsible for causing these kinds of avoidable losses, who knows how many different ways the "average Joe" might find to screw up a system where "traders need to consider not only the effect that each individual element usually has on price, but also how they typically impact on one another, and what the combined effect of such interactions is likely to be."

Moreover, even if trained to perfection, people being people, candidates are NOT going to execute according to protocol. They will sing up for the program laden with their own preexisting ideas, and when push comes to shove, act on what they think or are convinced they should do rather than what they were trained to do.

One sees this all the time. It's not unlike something I’ve witnessed who knows how often when visiting trading rooms online. You'll have someone like AJ Monte, who's been at this for umpteen years, respected in the industry and, based on the signals he sends out to his paying subscribers, very profitable. Then you'll have some wiseguy who is supposedly looking for help try to tell the "expert" where he or she is going wrong.

Of course, I'm thinking to myself, "Dude! He's making money and you're not. Why don't you just listen and try to learn something instead of attempting to get him to change his profitable way of doing things or have him operate in your way, you being someone who probably couldn't trade his way out of a paper bag? Or, if you know so much, why don’t you just go off and develop your own system?"

But then again, I completely understand, because I too have my own ideas and like to do things my own way. On the other hand, I never tried to get the likes of Melissa Armo, Nick McDonald, Anne-Marie Byrnes, Ziad Masri and Awais Bokhari, etc., to adopt one of my tactics instead of sticking to their own established way of doing things. And anyway, I actually did go off and develop my own system...obviously.

Why people are always lookin' to fix what ain't broke, I'll never know. So, if I'm going to have them trading my money, it will have to be according to my signals. Again, the aim of this firm (if it ever becomes a reality) will be to guaranty that people who simply want to make a buck online do so—and NOT to train people who want to lean how to trade, or to employ people who claim to already possess such knowledge.

And now, I'm thinking of adding something else to it ("it" being a different business model) that I did not originally have in mind, which is to determine/establish each employee's short- and long-term financial goals and guide them in their trading accordingly, also taking lifestyle and other considerations into account.

If fact, I'm thinking that perhaps I should even look into the possibility of making enrollment in some type of class on the management of personal finances a condition of employment so that the firm is not guilty of making people rich without also ensuring they are equipped to handle their newfound wealth responsibly (as lotteries are notorious for doing).

(P.S. Oh, and by the way… what's with all these guys I see online trying to hire someone else to pass a prop firm challenge FOR them? It seems to me that they should consider the possibility that this might not bode will for their future and long-term success.)

 

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So then, here are my questions for NADEX Customer Service...

"If I wished to set up as a proprietary trading firm (i.e., an LLC) would I be able to do so? (Does NADEX even provide prop firm certification?) And if so, what 'additional documents specific to my entity type' would I need to provide?"

Thank you for your interest in opening an entity account at Nadex. We would like some more information to continue your application. Please respond to the questions below, and our Account Opening department will contact you.

1.What type of entity do you have? (Trust, Partnership, LLC, Corporation). The entity must be registered in the US.

2.Do you or any of the intended entity traders currently have a Nadex demo or live account? If so, please give those usernames. (Your trading experience may help expedite the entity application process.)

**Each Nadex member may have only one live account. If you (or any entity owner or trader) currently have an individual account, you may continue trading it during the application process. You will need to close that account, but only after your entity application is fully approved.

3.What type of trading experience do you have?

·What trading experience do you have with this entity?

·What trading experience do you have with Nadex binary options?

4.In order to open an entity account with Nadex, you will need to obtain a Legal Entity Identifier (LEI). There is an initial fee to get this registration, plus an annual fee to keep the registration. There are multiple places you can obtain this registration, such as:

·Bloomberg
·GMEI Utility

You may wait until your entity account is fully approved to obtain this registration. If Nadex approves your entity account, are you willing to obtain a LEI, and keep it current as long as your entity account at Nadex is active?5

5. Please note that Nadex entity accounts are currently only compatible with our original web-based trading platform, PureDeal. Entity traders are not able to trade on the mobile app or new web platform. Are you willing to trade solely on the old platform?

6. Please provide us with a valid phone number where we can reach you. We may need to follow up with you regularly in order to get your application processed as soon as possible. What is the best number we can reach you at?

Once we have received your completed responses, our Account Opening team will contact you in 1-2 business days. If you have questions regarding this request, please do not hesitate to contact us.

 

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expiated-I would be happy to discuss how best to structure this. Just give me a call to give me details of Asset classes and scale, and we can discuss it. My phone number and email are below.

Dude is trading digitals with $20 payouts.

 

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Rough draft on which to base a final document...

Before you trade a penny with our firm, we will require you to address a few areas of importance, such as:

1. Draw a personal financial road map.

Before you make any investing decision, sit down and take an honest look at your entire financial situation—especially if you've never made a financial plan before.

The first step to successful investing is figuring out your goals and risk tolerance—either on your own or with the help of a financial professional. (There is no guarantee that you'll make money from your investments.)

2. Evaluate your comfort zone in taking on risk.

All investments involve some degree of risk. If you intend to purchase securities, it's important that you understand you could lose some or all of your money. Unlike deposits at insured banks and credit unions, the money you invest in securities typically is not federally insured. You could lose your principal, which is the amount you've invested. That's true even if you purchase your investments through a bank.

The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents.

On the other hand, investing solely in cash investments may be appropriate for short-term financial goals. The principal concern for individuals investing in cash equivalents is inflation risk, which is the risk that inflation will outpace and erode returns over time.

3. Consider an appropriate mix of investments.

By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can help protect against significant losses. Historically, the returns of stocks, bonds and cash have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns.

By investing in more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio.

To accommodate investors who prefer to use one investment to save for a particular investment goal, such as retirement, some mutual fund companies have begun offering a product known as a lifecycle fund, which is a diversified mutual fund that automatically shifts towards a more conservative mix of investments as it approaches a particular year in the future, known as its "target date."

A lifecycle fund investor picks a fund with the right target date based on his or her particular investment goal. The managers of the fund then make all decisions about asset allocation, diversification, and rebalancing.

It's easy to identify a lifecycle fund because its name will likely refer to its target date. For example, you might see lifecycle funds with names like "Portfolio 2015," "Retirement Fund 2030," or "Target 2045.”

4. Be careful if investing heavily in any individual stock.

One of the most important ways to lessen the risks of investing is to diversify you investments. It's common sense: don't put all your eggs in one basket. By picking the right group of investments within an asset category, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain. You'll be exposed to significant investment risk if you invest heavily in any individual stock. If that stock does poorly or the company goes bankrupt, you'll probably lose a lot of money.

5. Create and maintain an emergency fund.

Most smart investors put enough money in a savings product to cover emergencies. Some make sure they have up to six months of their income in savings so that they know it will absolutely be there for them when they need it.

6. Pay off high interest credit card debt.

There is no investment strategy anywhere that pays off as well as, or with less risk than, merely paying off all high interest debt you may have. If you owe money on high interest credit cards, the wisest thing you can do under any market conditions is to pay off the balance in full as quickly as possible.

7. Consider dollar cost averaging.

Through the investment strategy known as "dollar cost averaging," you can protect yourself from the risk of investing all of your money at the wrong time by following a consistent pattern of adding new money to your investment over a long period of time. By making regular investments with the same amount of money each time, you will buy more of an investment when its price is low and less of the investment when its price is high. Individuals that typically make a lump-sum contribution to an individual retirement account either at the end of the calendar year or in early April may want to consider "dollar cost averaging" as an investment strategy, especially in a volatile market.

8. Consider rebalancing your portfolio occasionally.

Rebalancing is bringing your portfolio back to your original asset allocation mix. By rebalancing, you'll ensure that your portfolio does not overemphasize one or more asset categories, and you'll return your portfolio to a comfortable level of risk.

Also, shifting money away from an asset category when it is doing well in favor an asset category that is doing poorly might not be easy, but it can be a wise move. By cutting back on the current "winners" and adding more of the current so-called "losers," rebalancing forces you to "buy low and sell high."

You can rebalance your portfolio based either on the calendar or on your investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing. Others recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you've identified in advance. The advantage of this method is that your investments tell you when to rebalance. In either case, rebalancing tends to work best when done on a relatively infrequent basis.

9. Avoid circumstances that can lead to fraud.

Scam artists read the headlines, too. Often, they’ll use a highly publicized news item to lure potential investors and make their "opportunity" sound more legitimate. The SEC recommends that you ask questions and check out the answers with an unbiased source before you invest. Always take your time and seek wise counsel before investing.


Sample of the kind of questionnaire you might want to have new employees/junior traders complete...

https://investor.vanguard.com/tools-calculators/investor-questionnaire

 

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More sample language/verbiage...

The allocations suggested by most financial advisors are typically based on generally accepted investment principles. Yet, there's no guarantee that any particular asset allocation or combination of investments will meet an individual investor's objectives. Moreover, all investments involve risks, and fluctuations in the financial markets and other factors may cause the value of one's account to decline. You should therefore consider all of your options carefully before investing.

And bear in mind that an investor questionnaire doesn't provide comprehensive investment or financial advice, and the firm isn't responsible for reviewing your financial situation or updating the suggestions stemming from a given questionnaire.

 

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From the Vanguard site...

Once you start withdrawing and spending your money, you'll want to be sure it will last as long as you need it to. Depending on your goal, that could be a short or long period of time. It might be a onetime expense, such as buying a house, several years of paying college tuition, or even decades of enjoying a long retirement. These future plans are important to consider when mapping out an investment strategy.

Estimate the amount of time you have until you need to start spending the money you're investing. If your time frame is short, we'll suggest a more conservative allocation to preserve your assets. If you won't need the money for many years, we'll suggest an allocation that will give your assets the potential to grow over time.

 

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When it comes to investing in stock or bond mutual funds or ETFs - or individual stocks or bonds - I would describe myself as...

• Very inexperienced
• Somewhat inexperienced
• Somewhat experienced
• Experienced
• Very experienced

 

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I plan to begin taking money from my investments in...

• 1 year or less
• 1-2 years
• 3-5 years
• 6-10 years
• 11-15 years
• More than 15 years