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The Benefits of Joining a Prop Firm - Leverage
A new article from John Knott, better known as ACD on the boards. John manages the Chicago regional office for VTrader Group, a proprietary trading firm that specializes in stock, options and futures trading.
Enjoy!
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I would like to spend some time discussing the benefits of joining a prop firm. More specifically the type of prop firm where the trader makes a capital contribution since these are the most readily available and easiest to get into for most traders. I often get asked what’s the real benefit for joining one of these firms. It seems as though this part of the industry is the shadiest with most traders holding negative opinions of these firms.
Obviously all these firms have different things to offer. Some firms specialize in only equities while others allow you to trade anything. A majority of them require you to not hold any overnight positions; however there are other firms like VTrader and Bright Trading that do allow overnight positions. What most of these firms have in common is professional leverage and the ability to work in an office environment with other traders.
Let's discuss leverage. While all these firms offer leverage, the type of leverage actually varies a lot. Many of the equity firms offer fixed leverage. For example, you will see advertised 20 to 1 leverage on deposit capital. Remember Reg T offers 4 to 1 intra-day and 2 to 1 overnight for retail traders. Other firms provide unlimited intra-day leverage. It's unlimited to the extent of the volatility of your P&L. For example, if you have 25k on deposit and your daily swings are 1k to 2k, the firm may not care how much leverage you are using to produce those swings. If that trader were to drop 5k in a day, then share or position limits might be enacted.
Firms who allow traders to hold overnight positions often use what is referred to as haircut or risk based haircut. This is the case with firms like VTrader or Cassandra Group where traders are holding stock, option and future positions overnight and their risk is determined by taking various fixed percentage moves of the underlying positions both up and down to come up with the required capital to hold a position. In many cases this can be anywhere from 5 to even 100 times the amount of leverage one could get in a retail account.
For equity traders, one of the biggest annoyances they face in the retail world is the pattern day trader rule which requires one to open an account with at least 30k and maintain a balance of 25k or more at all times. These are often the traders who are attracted to the 5k and 10k deposit equity shops, just to get around the PDT rule. Also proprietary in house software that allows traders to pair trade equities or engage in high frequency scalping is also an attractive incentive.
For option traders, the ability to not have to pay cancel fees on option orders and also the ability to offset the risk in their positions in ways in which retail brokers will not offer an margin relief. For example, say you are long 5 different NASDAQ options and are short the NDX against it, in a retail account you are going to put up the full margin for both positions. At a prop firm, you would be able to hold a size position with very little margin requirement.
Another similar example, say one is long 10 different NASDAQ stocks and short the NQ futures against them. Same deal, in a retail account you would put up the full Reg T margin for each of the stocks as well as the full exchange margin for the futures contract. This has a substantial effect on return on equity. Notice how in these examples the leverage in many cases is not used to increase risk but actually decrease your risk.
Another advantage is the ability to use your capital for both long term and short term trading. Let me give an example, say one wants to put on an assortment of long stock positions, option positions and some ETFs for longer term trades. The problem is, in a retail account, all your margin is used up and you have no capital to day trade. So traders often have to choose one or the other. At a prop firm, traders can hold long term positions with all of their risk capital and still engage in active day trading whether it be stock, options or futures scalping.
There is another aspect of leverage that needs to be discussed and that is the margin call. In a retail account, leverage often leads to margin calls and forcing traders out of positions at extreme ends of moves. Usually once your positions have been liquidated, the market will recover or revert back to where your positions would not only make back their losses but in many cases, return to profitability. With prop firms, there are no margin calls. You will have to work with risk management and actively hedge your positions, but it's the fact that you can do this that makes it so valuable. For example, if you are carrying overnight option positions and are overweight long deltas in a falling market, rather then blow out of your positions at market prices getting killed on slippage, you could sell ES mini contracts short. Plenty of liquidity, one tick spreads and you can stop the bleeding instantly. In fact, you may even be able to profit from your hedges as well as profit from the very positions that were giving you the trouble in the first place. You simply cannot do this in a retail account or even a customer portfolio margin account. It is often these rare days that will make the difference between a trader blowing out and losing all their capital and living to fight another day.
As you can see, leverage is not just important to enhancing returns, but it's vitally important to protecting your positions and your capital and keeping you in the game. You simply cannot get this leverage in a retail account nor have the diversity of options to protect yourself. The trading game is about making money, but it's also about protecting what you have. And that means you need to be able to act and hedge on the fly without coming up against the restrictions placed upon retail traders. This is why most retail traders are best left to long term investments. Sooner or later, any retail trader that tries to step across the line and leverage their account and trade like a professional trader, sooner or later they will understand that while it may be easy putting the positions on, it will be impossible to take them off without considerable damage.
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