Prop Trading: Strategies and Insights

Over the years, I have been quietly putting down notes and strategies on trading alphas. With the wisdom of time and experience, I am consolidating some insights here, to spark further discussions with friends and colleagues.

Although my recent energy has primarily centred around tech startups, or, more humbly – small online businesses, current client engagements are rekindling my focus and drawing me once again into the realm of trading. This presents a opportunity to kill-2-birds-with-1-stone: to not only excel in doing client work but also to go into electronic trading, which I desired to do so previously.

Here we want to talk about trading, in the sense of prop trading. I am not referring to the conventional asset or wealth management realms where the mantra might be a simplistic “long-only” approach. Instead, I am delving into proprietary trading, with aspirations for a Sharpe ratio > 2.

To embark on this journey, it’s imperative to first outline our tradable universe, especially from the vantage point of a boutique fund, a prop trading firm, or a Singapore-based family office.

Tradeable Universe

These instruments should be accessible to most market participants.

1. Equities: Stocks from various sectors and sizes, domestically and internationally.
2. Fixed Income: Bonds ranging from government to corporate and municipal.
3. Derivatives: Instruments including options and futures.
4. Commodities: Encompassing energy sources, metals, and key agricultural products.
5. Forex: Mainly major, minor, and exotic currency pairs.
6. Cryptocurrencies: Digital currencies like Bitcoin, Ethereum and Altcoins.
7. Funds: Focusing on ETFs, mutual funds, and associated arbitrage opportunities.
8. Volatility Indices: Primarily VIX futures, which serve both as a measure of market volatility and a tradable asset.

Next, let’s just jump straight into key prop trading strategies, bucketed into identifiable categories, before commenting more on each.

Prop Trading Strategies

Let us speed run through the array of strategies available. Remember, while carry and positional trades offer potential gains, they carry risks, especially if market structures or curves shift unexpectedly. For those who prioritize risk-adjusted returns, consider arbitrage strategies. They often allow for potential profit locking or effective risk hedging. I may come back to delve deeper into any strategy that piques your (user) interest.

Carry Trades

FX Carry Trade

The FX Carry Trade leverages the differential between interest rates of two currencies. Traders borrow in a currency with a low-interest rate and invest in another with a higher rate, pocketing the difference.

Example: If the US offers an interest rate of 5.5% and Switzerland’s rate stands at 1.75%, a trader borrowing 1 million CHF at 1.75% and investing in the US at 5.5% would capitalize on a 3.75% differential. However, fluctuations in exchange rates can pose risks. Utilizing forward contracts, traders can lock in future exchange rates, safeguarding against potential currency movement losses. Morgan Stanley Private Bank used to like to pitch this trade, cause it is as low risk as it gets in the trading spectrum.

Commodity Carry Trade

Traders exploit the futures market dynamics, profiting from contango situations by shorting futures while holding the physical commodity. In backwardation, they might either go long on futures or buy commodities at a futures discount, selling them later at a higher spot price.

Example: If crude oil’s spot price is $80/barrel and a six-month future contract is priced at $85, a trader could buy the oil now and simultaneously short a futures contract. The anticipated profit would be the $5 differential, minus storage or other associated costs.

Yield Curve Carry Trade

This strategy focuses on the yield curve, which relates interest rates to bond maturity. A pronounced difference between short-term and long-term rates (steep yield curve) provides an opportunity. Traders borrow at short-term rates and invest in long-term bonds, pocketing the yield differential.

Example: With a 3-month rate at 1% and a 10-year bond yield at 4%, a trader borrowing $1,000,000 short-term and investing it long-term would anticipate a yearly profit of $30,000, barring any significant yield curve shifts.

Basis Arbitrage Carry Trade

This centers on the ‘basis’ difference between an asset’s spot and futures prices. As the futures contract nears maturity, this basis should narrow, providing an arbitrage opportunity.

Example: If Bitcoin’s spot price is $50,000 and its three-month futures price is $52,000, the basis is $2,000. Purchasing Bitcoin at the spot price and shorting a futures contract would, upon maturity and assuming alignment of the two prices, yield a $2,000 profit.

Bond Carry Trade

Traders exploit interest rate differentials between countries. Borrowing in a currency of a low-yield country and investing in bonds of a high-yield country results in profit from the rate difference.

Example: In Country A, bonds yield 1%, while in Country B, they yield 5%. Borrowing $1,000,000 from Country A and investing in Country B would lead to a profit of $40,000. However, if Country B’s currency depreciates by 2%, the net profit would reduce to $19,200.

Volatility Carry Trade

During stable market periods, volatility tends to be predictably low. Traders can sell or “short” volatility through instruments like VIX futures, profiting if they can later repurchase these instruments at a decreased price.

Example: If a VIX future is sold at $20 and later repurchased at $15, the trader realizes a profit of $5 per contract. However, unexpected market events can lead to spikes in volatility, affecting this trade.

Credit Carry Trade

This strategy involves going long on high-yield corporate bonds and shorting safer government bonds. The yield differential serves as the potential profit.

Example: A trader goes long on a high-yield corporate bond yielding 7% and shorts a government bond yielding 2%. For a $1,000,000 investment, the anticipated yearly profit is $50,000 (5% differential). However, the risk of corporate bond default or downgrading can impact returns.

Emerging Market Carry Trade

Emerging markets, due to perceived growth and risk, often have higher interest rates. Traders borrow in developed, low-interest-rate markets and invest in high-yielding instruments in emerging markets.

Example: Borrowing $1,000,000 in a developed market with a 2% rate and investing in an emerging market bond yielding 8% would result in a yearly profit of $60,000. Some trading desk do this and hedge the forward FX risk. But, risks like political instability or currency depreciation in the emerging market can affect profitability.

Cross Venue Arbitrage

Cross-venue arbitrage takes advantage of price discrepancies for the same asset across different exchanges or trading venues. In an efficient market, an identical asset should have a consistent price everywhere, but in reality, variations can occur due to factors like liquidity, trading volumes, local market conditions, and technological differences. I like this strategy.

Here’s a more detailed look at how this strategy might work:

1. Traditional Financial Markets: An example could be buying a cheaper American Depository Receipt (ADR) on one exchange while simultaneously selling the equivalent local stock on another and then hedging the foreign exchange exposure. If direct hedging is too costly, a “dirty hedge” might be used with a correlated asset like futures.
2. Cryptocurrency Markets: Consider a highly liquid exchange like Binance, where a specific cryptocurrency might be trading at one price, and a less liquid, smaller exchange where the same cryptocurrency could be trading at a slightly different price. Traders can simultaneously buy low on one exchange and sell high on the other, capturing the difference as profit.
3. Layer 1 and Layer 2 Blockchain Networks: In the world of decentralized finance (DeFi), opportunities might arise between the main blockchain (Layer 1, like Ethereum) and its Layer 2 solutions (like Optimism or Arbitrum), which aim to enhance scalability. Price discrepancies between these layers can create arbitrage opportunities, especially during times of high network congestion.

One famous historical example of cross-venue arbitrage is the “Kimchi premium” where certain cryptocurrencies traded at higher prices on South Korean exchanges compared to others globally.

It’s essential to note that these opportunities are often fleeting. Price alignment typically starts from the most liquid venues and gradually influences the less liquid ones. As more traders exploit these discrepancies, the gaps tend to narrow, reducing the potential for profit. Furthermore, transaction fees, transfer delays, and regulatory considerations might add complexity to the execution of these strategies.

Cross-venue arbitrage can be lucrative, especially for those with the technological means to spot and act on these opportunities quickly. However, it may not be a long-term, sustainable strategy. Traders must remain adaptable and aware of changing market dynamics, as what works today may not be as effective tomorrow.

Momentum and Trend

Momentum and trend trading operate on the foundational principle that assets which have been moving in a particular direction are likely to continue moving in that same direction. This strategy capitalizes on the inertia of price movements, rather than on the asset’s underlying fundamentals. Easy to start with.

Here’s a deeper dive into this trading strategy:

1. Understanding Momentum: At its core, momentum trading is a strategy that seeks to buy assets that are rising and sell those that are falling. It’s predicated on the idea that assets that have been performing well will continue to do so, while those that have been underperforming will continue on a downward trajectory.
2. Absolute vs. Relative Momentum: While absolute momentum looks at an asset’s performance relative to its past performance, relative momentum compares the performance of multiple assets to one another. For instance, if Stock A has risen 10% over the past month and Stock B has risen 5%, a relative momentum strategy would favor Stock A. Conversely, an absolute momentum approach might only consider Stock A’s recent performance in isolation, without comparing it to other assets.
3. Non-Correlated Assets: Diversifying a portfolio with non-correlated assets is essential in momentum trading. The goal is to combine assets that don’t move in tandem, ensuring that even if one asset starts to reverse its trend, the entire portfolio doesn’t suffer. This approach can help in reducing volatility and enhancing returns.
4. Simple Indicators: One doesn’t always need complex algorithms or indicators to identify momentum. Simple moving averages (SMA) are often enough to gauge an asset’s momentum. For instance, if an asset’s price is above its 50-day SMA and continues to rise, it might indicate a strong upward momentum. Conversely, if it’s below this average and declining, it could suggest a downward trend. Using two SMAs — one short-term and one long-term — can also help traders spot potential trend reversals or confirmations. For instance, when a short-term SMA (like the 50-day) crosses above a longer-term SMA (like the 200-day), it’s often seen as a bullish sign.
5. Caveats: Like all strategies, momentum trading isn’t foolproof. Trends can reverse unexpectedly due to various factors, including shifts in market sentiment, major news events, or changes in an asset’s fundamentals. Hence, it’s crucial for traders to set stop losses, continually monitor their portfolios, and be prepared to adjust their positions as market conditions evolve.

While momentum and trend trading can be a highly effective strategy, especially in strong trending markets, it requires discipline, continuous monitoring, and a sound risk management approach. The use of simple tools, like the SMA, makes it accessible even to novice traders, but understanding the nuances and intricacies is essential for long-term success.

Risk Premia Harvesting

Risk premia harvesting is a sophisticated investment strategy that revolves around capturing additional returns by taking on specific types of risks. These “premiums” are the extra returns an investor can expect to earn for holding riskier assets compared to risk-free alternatives. This is wealth management 101 – stonks only go up.

Here’s a detailed breakdown:

1. Equity Risk Premium (ERP): The most renowned of all risk premia, the equity risk premium represents the additional return investors expect for holding a risky equity over a risk-free asset, like a government bond.Mathematically, it’s defined as:
   Equity Risk Premium (ERP)=Expected Return on Equity−Risk-Free RateEquity Risk Premium (ERP)=Expected Return on Equity−Risk-Free RateFor instance, if the expected return on a stock is 8% and the risk-free rate is 2%, the ERP is 6%.

2. Size Premium: Smaller companies, often with lower market capitalizations, tend to have stocks that are riskier than large-cap stocks. This added risk means investors expect a higher return for holding these stocks. The size premium is the extra return investors anticipate from small-cap stocks over their large-cap counterparts.
3. Value Premium: Value stocks, or those considered undervalued compared to their intrinsic value, have historically outperformed growth stocks. The value premium is the additional return investors expect for holding these undervalued stocks.
4. Liquidity Premium: Assets that aren’t easily traded or converted into cash often come with a higher expected return to compensate for their lack of liquidity. This extra return is the liquidity premium. For example, stocks that trade less frequently or in smaller volumes might offer a liquidity premium over more heavily traded stocks.
5. Credit Premium: This pertains to the bond market. Bonds with lower credit ratings (or higher default risk) offer higher yields to compensate investors for taking on the extra risk. The credit premium is the additional yield over a risk-free or higher-rated bond.
6. Diversification Across Risk Premia: To mitigate the inherent risks and achieve more consistent returns, savvy investors often diversify their portfolios across various risk premia. This ensures that even if one asset class underperforms, others might outperform, leading to a smoother overall return profile.
7. Additional Strategies:
   • Long Equity: Simply put, betting on the overall upward movement of the stock market.
   • Yield Curve Carry: Profiting from the differences in interest rates across various maturities.
   • VIX Futures Roll Down: A strategy involving the VIX volatility index, where traders aim to profit from the difference between spot VIX and futures VIX prices.
   • Selling Equity Volatility: Essentially, betting that stock market volatility will decrease.
   • Discounted Closed-End Funds: Buying funds that trade at a price lower than their net asset value, anticipating a price correction.
   • Weekend Business Hour Effects: Exploiting predictable patterns in asset returns based on the day of the week or business hours.

Risk premia harvesting is about being compensated for enduring the unpredictability of certain assets. By understanding the different types of risk premia and employing a diversified approach, investors can aim for consistent, risk-adjusted returns over the long term.

Replicating Basket Arbitrage

Seasonal Effects

Seasonal effects refer to recurring patterns in asset prices based on specific time cycles. These cycles could be influenced by various factors, ranging from cyclical business trends to behavioral nuances of market participants. Recognizing these patterns can offer traders potential opportunities to capitalize on predictable price movements. Easy and useful point of discussion between salespeople and trader.

Let’s delve deeper into the nuances of seasonal effects:

1. Business Cycles and Seasonality: Certain industries have inherent seasonality. For instance, retailers might see increased sales during holiday seasons, while travel companies may experience a surge during summer vacations. These cyclical business trends can influence stock prices, providing traders with insights into potential bullish or bearish periods.
2. Commodity Seasonality: Many commodities display clear seasonal patterns. For instance:
   • Heating oil typically sees heightened demand during colder months, pushing prices higher.
   • Agricultural commodities can be influenced by planting and harvesting seasons.
3. End-of-Month Window Dressing: Fund managers, especially those of mutual funds, often adjust their portfolios towards the end of a reporting period to improve the appearance of their holdings. This practice, known as “window dressing”, can lead to short-term price distortions. For instance, moving into traditionally “safe” assets like Treasury bonds (e.g., TLT) can push prices higher towards the month’s end.
4. Mechanical Adjustments: Some financial products, like bond ETFs, need to make regular purchases or sales to maintain their target duration or other fund characteristics. These mechanical adjustments can create predictable price movements as they are often based on set criteria and are publicly known.
5. Behavioral Patterns: There are also seasonality patterns linked to human behavior and psychology. Examples include the “January Effect,” where stocks, especially small caps, tend to rise in the first month of the year, or the “Sell in May and Go Away” adage, suggesting equities perform better in the winter months compared to summer.
6. Risks and Considerations: While seasonal effects provide intriguing trading opportunities, they don’t guarantee profits. Various external factors, like unexpected macroeconomic events, can disrupt seasonal patterns. Moreover, as more traders become aware of these effects, the advantage may diminish over time.

Seasonal effects shed light on the rhythmic nature of financial markets. By understanding and harnessing these patterns, traders can potentially position themselves more favorably. However, as with all strategies, a comprehensive analysis and risk management approach are essential.

Technical Supply/Demand Imbalances

Technical supply/demand imbalances in the financial markets can offer traders lucrative opportunities. These imbalances often arise when there’s a sudden shift in the equilibrium between buyers and sellers, causing a temporary mispricing of an asset. Recognizing and capitalizing on these imbalances requires speed, precision, and a thorough understanding of market mechanics. Another bread and button of prop shops.

Here’s a deeper dive into the topic:

1. Catalysts for Imbalance: Events like unexpected news announcements, earnings reports, or governmental policy changes can trigger rapid repricing of assets. For instance, a surprise central bank decision might cause a currency’s value to spike or plummet in minutes.
2. Overbought and Oversold Conditions: These conditions arise when an asset’s price moves too far, too fast, typically as a reaction to significant news. An overbought asset is one that has been purchased excessively and might be priced higher than its intrinsic value. Conversely, an oversold asset might be undervalued because of excessive selling. Recognizing these conditions quickly and trading accordingly can yield profits as prices revert to their mean.
3. Large Order Flows: Sometimes, significant buy or sell orders, especially from institutional investors, can cause temporary price distortions. These large orders might push prices away from their equilibrium, creating a potential opportunity for traders to capitalize on the subsequent price correction.
4. Price-Insensitive Trading: Certain traders or algorithms might execute trades without considering the asset’s intrinsic value. For instance, during portfolio rebalancing, asset managers might buy or sell assets to maintain a specific portfolio allocation, irrespective of the current market price. Recognizing such price-insensitive trades can allow opportunistic traders to position themselves advantageously.
5. Strategies to Capitalize:
   • Fade Strategy: This involves trading against the prevailing market trend. For instance, if there’s a sudden surge in a stock’s price due to an imbalance, a trader might decide to “fade” or short the stock, anticipating a pullback.
   • Curve Arbitrage: If a large order creates a distortion in a pricing curve, traders can buy the undervalued asset and sell the overvalued one, profiting from the price discrepancy.
   • Risk Offset: After recognizing an imbalance, traders might look for correlated assets to hedge their positions, minimizing potential losses if the market doesn’t correct as anticipated.
6. Risks and Considerations: While trading based on supply/demand imbalances can be profitable, it’s not without risks. Predicting when the market will correct itself is challenging, and there’s no guarantee that prices will revert to the mean in the expected timeframe. Additionally, external factors like further news or macroeconomic events can exacerbate imbalances.

Technical supply/demand imbalances provide a window into the market’s real-time reactions to events and order flows. By understanding these dynamics and acting swiftly, traders can position themselves to potentially capture short-term profits. As always, robust risk management practices are crucial to navigate the inherent uncertainties.

Special Situations Arbitrage

Special situations arbitrage is a different kind of trading strategy. Instead of just looking for price differences between markets or assets, it focuses on making money from unique, one-time events. These can be things like company changes or sudden market shifts. The exciting part? This strategy can sometimes give big profits quickly.

However, it’s not always easy to spot these opportunities.

What Are Special Situations?

“Special situations” are unique events in the market. They’re not the usual investment opportunities but come from unexpected events that cause short-term market changes. These don’t happen regularly; they’re more like rare episodes.

The Importance of a Scanner

Because these chances can come and go quickly, having the right tools is crucial. Think about creating a scanner that can spot these rare opportunities fast. This scanner can help traders act quickly and benefit from these short-lived chances. Like monitor algorithmic stable coin depegging in the past.

Notable Examples

To grasp the potential of special situations arbitrage, consider a few examples:

1. LUNA/UST Arbitrage: A unique opportunity arising from the dynamics between LUNA and UST.
2. Depreciation Arbitrage: Capitalizing on coin depeg events that have historically presented lucrative opportunities.
3. ETH Merge Arbitrage: The ETH merge event led to significant price disparities between lesser-known exchanges and their larger counterparts, with arbitrage spreads reaching staggering levels.

What to Trade

Deciding what to trade hinges on several factors. Firstly, lean into your expertise. Trading in markets or sectors you understand gives you a competitive edge. It’s essential to align this knowledge with your goals, determining if you’re in for the short haul or the long game, and gauging your comfort with risk. Remember, high rewards often come with increased volatility.

Accessibility is another consideration. Ensure that your platform and location allow you to tap into your desired markets and that you’re equipped to trade your preferred financial instruments. Moreover, the quality and relevance of data can make or break a trade. Use both traditional and alternative data sources, ensuring they’re pertinent to your asset focus.

Technological prowess can set you apart. Investing in advanced research tools and trading platforms can streamline your decision-making and execution. However, it’s not just about internal factors. Being attuned to external influences, such as regulatory changes and macroeconomic shifts, can significantly impact your asset choices.

Personally, I am interested into looking at arbitrage, pseudo-arbitrage of trades, which falls under the replicating baskets. The price of the replicating basket should hover around a fair value and you can just trade around it. For me, I can program and might electronically quote / trade the fair value. The challenge is to find your replicating basket which gives you ample opportunities to trade in your size – the prize is to find many small repeating trades which allow you to compound your edge.

How to Trade

To succeed in trading, you need knowledge, strategy, and discipline. Start by choosing assets that fit your expertise and risk tolerance. Then, set up a signal screen based on technical or fundamental analysis to guide your decisions. For example, forex traders might track ‘pips per day’, while bond traders focus on ‘basis points per day’.

Stay updated by regularly scanning your asset choices. Use automated scans on modern platforms to get alerts when specific criteria are met. These alerts help you catch important market changes. If you are too busy, we at Latent Markets can build you automated scans and custom dashboards or reports tailored to your needs.

When you get an alert, review the situation and check if it matches your strategy. If it does, make your trade. Always stick to your set rules; it’s discipline that often defines a successful trader. Sometimes, you just have to do the boring, repeating stuff.