Prop Trading Primer

Trading is a very difficult job, not only because of the technical requirements but also because of the mental toughness and discipline it requires. Many retail traders don't realize it, but they are in fact proprietary traders. They trade their own capital and in this sense are doing exactly what professional money managers and hedge fund traders do: take on market risk with a directional bias. In this article, we'll try to do an overview of what exactly "proprietary trading" means and why having the right mindset is important.

1. What is your job?

We are in the realm of proprietary trading. That means that we risk our own capital in order to come out with more than we went in with. This is totally different from the Sales Trading positions that big Investment Banks offer. Sales Trading and Dealing are commission-based activites, that are meant to create liquidity for market participants (their clients & counterparties) taking on as little market risk as possible. They need to be good at hedging their positions. Prop-trading is a totally different story. Prop-traders take on market risk because they have faith in their capability to predict market behaviour.

So the prop-trader needs to predict market behaviour – not “the future”. There is a big difference here and that's what we're going to focus on in this article. I'm going to demonstrate why prop-trading is possible (contrary to the Efficient Market Hypothesis) and why it hinges on the fact that financial markets are made up of human interaction.

Everything will become clear after this example:

You have a 9 to 5 job and you're waking up on a weekday. In your experience, you know that you have an hour before having to catch the bus that takes you downtown. So your experience has allowed you to create a routine so you will be prepared and ready to get to the bus stop on time. You will also be able to predict that the bus will arrive on time, most of the time. You also know that when it's late, it arrived 5 minutes later; and you know that it's unusual for the bus to arrive early. In the same way, you can predict with a certain accuracy when it's best to avoid the freeway because of rush-hour. You can also predict at what time you'll have to take your siblings to school.

The point is that predicting mass behaviour (or “herd behaviour” as the institutionals commonly refer to us) is relatively simple if you observe what happens and when it happens and how it happens. Yes, you got it: humans are creatures of habit. And because the markets are made out of human interaction (or robots programmed by humans), it makes the markets somewhat predictable. 

So you may ask: why does it take so long for a trader to learn and become consistently profitable? Aside from the fact that I might have a low "trading-IQ", one thing I've figured out is that the distance between the brain and the finger might not be so close as you'd think - if you're not careful. I know I'm not the only trader who has repeated the same mistakes, or variations of same. My contention is that old habits die hard. Real hard. And only if you deliberately plan to kill them.

2. On the correct thought process

Trading is difficult also because the thought process required is almost diametrally opposite to what our education systems teach us. “Learn the facts, not the analytical thought process that led to the fact”: that's the common message. Memorize and regurgitate the knowledge of great minds and their opinions. This just doesn't work in financial markets. You need to open your eyes, think logically, observe in a critical way and put your observations to the test. It's very much like the good old scientific method from the 1700s, where observation, experience & knowledge come together and translate into practice. That's why they say “you must talk the talk and walk the walk”.

In the process, you must be aware of the level of abstraction you're on. You need to be very much aware of what can be tested & verified, what is assumed, what is suspect. If you want to trade professionally then you will need to observe directly (real time charts in front of you), know your level of abstraction (you're using a chart which is only a map – it's not reality), the lessons learned through experience (which should be detailed in a trading diary), recognition of similarities and differences, and the use of all external help (books, trading seminars, etc.).

So traders usually trade using a chart. Take note that the chart is not reality. The chart is an abstraction. The chart is only a “map of reality” but if you resist the temptation to clutter it up with fancy lines, then it's a clear enough map to guide you. You must respect a couple of rules though:

1) You must know whether your way of reading the map applies to reality. Basically I mean that all traders look at the same charts but many just can't get their head around a simple set of logical rules that keep them out of harms way.

2) The map of reality (the chart) is only a guide. Just like a real map, your objectives will decide the level of detail your map will need to show. Get in too close and you'll miss the context. Get too far away and you'll have a tough time getting a good risk-reward ratio on your trades.


Looking too close - this view is like looking at a specific neighbourhood on the map, when you still have to get out of the city. You see the trees but not the forest.
Source: FXCM marketscope

Looking from too far away - this is like having to get somewhere but looking at the map of a while state or country. You see the forest, but not the trees.
Source: FXCM Marketscope

The sweet spot - you see some of the forest and some of the trees. Generally speaking, it may be 2 months of data if you're looking for intraday to multi-day positions. 
Source: FXCM Marketscope

Where is the market going? What stance should I take? Long? Short? Flat? When using a map to get somewhere, you need to know where you're going. In a similar fashion, your "map of reality" needs to give you a direction. A logical way to do this is to take not of the opening prices of the week and of the day, trying to go with the flow.
Source: FXCM Marketscope

3. On imperfect information

The moment we are confronted with a choice (to buy, to sell, to hold, to fold, to walk away), our brains love certainty. But mother nature, life and the financial markets are not black & white. There are always exceptions; there are always situations that seem absolutely clear to you, only to find out later that you were ill-informed. In the markets, as in life, this assolves us from having to be right or wrong and give us the opportunity to be agile, practical, thoughtful – we can cut our loosers and ride our winners.

It's horrible to build your life around terms like “I don't know, maybe, up to a certain point, probably” but if you want to trade then there's no other way that I know of. So the average trader will smack some fancy lines on his chart, use oscillators he knows nothing about, use “guru” reccomendations trying to find that degree of certainty that he doesn't have. He will then believe any bit of nonsense that is said with convinction. And at the end, taken by fear, he'll decline all responsibility and will delegate the decision making to others.

You cannot have an answer to all questions. That would be asking too much. We are using a chart as our guide and you cannot try to impose a structure on something that does not have one.


Bottom line: observe HOW price moves and WHAT price tells you when it starts to behave differently. Major losses come when you have a closed mind and are not able to see that conditions have changed. Of course, reducing losses doesn't make you a winning trader. But it does limit the amount of stress you're under, because the hardest part of this business is accepting losses as a part of doing business. Nothing more, nothing less. You cannot avoid them. So learn to deal with them.

References:

1. Orderflowtrading for fun and profit - Daemon Goldsmith 2011
2. Investment Psychology Explained - M.J. Pring
3. Winning the Mental Game on Wall Street - John Magee