If trading is a losing game, how do you explain prop firms?

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boggler
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If trading is a losing game, how do you explain prop firms?

Post by boggler »

The common wisdom here is that indexing is the best strategy over time. Thus, trading stocks back and forth repeatedly, perhaps at high-frequency, is likely to underperform the market over time. Many Wall Street firms recognize this, but continue to trade because they are investing other people's money and thus get to charge a fee regardless of actual performance.

But if this is true, how do you explain the existence of proprietary trading firms, which exist to trade their OWN capital? (Many of these firms act as market makers or participate in HFT strategies, and many are quite profitable.) In other words, if those that know the most about the financial markets, know the theory behind indexing, and have the best access to the markets continue to trade, how can trading truly be a losing strategy? Or is it just a losing strategy if you don't have access to the resources of those firms?
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Re: If trading is a losing game, how do you explain prop fir

Post by richard »

I don't believe it's impossible to beat the market (many do it out of blind luck, if nothing else) or that there can't be talented traders out there (we don't have enough data to prove it either way). I just think that neither of us are talented traders and that neither of us have the ability to identify talented traders and, even if we were somehow able to identify them, they would charge high enough fees that they would get the benefits of their abilities, not us.
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Re: If trading is a losing game, how do you explain prop fir

Post by JoMoney »

In aggregate, trading in an attempt to beat the market is zero-sum minus expenses, no way around it. That doesn't mean there are no "winners", it just means that if there was no particular advantage possible the odds of outperforming might be 50/50 and that each transaction would create a cost that would essentially decrease the odds of outperforming net of expenses.
But as the recent and ongoing scandals often bring to light ( https://www.sec.gov/spotlight/insidertr ... ases.shtml ) advantages in information sometimes create opportunities with an advantage. There's also arbitrage opportunities and ability to front-run orders with speed advantages and various perfectly legal advantages. But if you aren't certain you have some piece of information or something that gives you an advantage in the trading game, I don't see how anyone can justify getting involved in it. In order to beat the market (outperform whatever the market returns), you have to know something the market doesn't (or rely on luck... essentially concede that the trading is not investing, but gambling).
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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boggler
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Re: If trading is a losing game, how do you explain prop fir

Post by boggler »

Why do the big banks engage in trading, given that they are run by smart people who presumably know all this?
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Dutch
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Re: If trading is a losing game, how do you explain prop fir

Post by Dutch »

Insider trading, that's how I explain it
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Re: If trading is a losing game, how do you explain prop fir

Post by Raybo »

One angle is unequal amounts at risk.

I see it like running a casino. The house has a much larger stake than any single bettor. If the game goes on long enough, the bettor will hit a bad streak and run out of money.

The proprietary trading firms have huge bankrolls. If you are betting against them, they will be able to push whatever you are investing in below your solvency point and take your money when you are forced to sell for a loss.

It isn't beating the market, so much, as beating (up) a lesser investor.
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Re: If trading is a losing game, how do you explain prop fir

Post by Ged »

I imagine these prop trading operations have low expenses plus serious systems support.

This means frequent trading doesn't cost them much so they can engage in strategies that don't work for the small guys.

The systems support allows them to take advantage of information faster than the rest of the market can. So for them the EMH doesn't apply - they are doing the price discovery faster than anyone else can afford to.
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Re: If trading is a losing game, how do you explain prop fir

Post by Methedras »

boggler wrote:Why do the big banks engage in trading, given that they are run by smart people who presumably know all this?
Because banks hire all these smart people to gain the market advantage. It doesn't have to be related to any illegal or immoral practices (as some may suggest), it can be that large banks simply use their immense capital resources and infrastructure to take advantage of market opportunities when they see them.

I don't think the Boglehead philosophy says that market arbitrage is inherently impossible, but that the evidence is pretty clear that the individual investor has no access to these arbitrage opportunities.
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Re: If trading is a losing game, how do you explain prop fir

Post by nedsaid »

I suppose they take advantage of amatuers like us.
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boggler
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Re: If trading is a losing game, how do you explain prop fir

Post by boggler »

Methedras wrote:
boggler wrote:Why do the big banks engage in trading, given that they are run by smart people who presumably know all this?
Because banks hire all these smart people to gain the market advantage. It doesn't have to be related to any illegal or immoral practices (as some may suggest), it can be that large banks simply use their immense capital resources and infrastructure to take advantage of market opportunities when they see them.

I don't think the Boglehead philosophy says that market arbitrage is inherently impossible, but that the evidence is pretty clear that the individual investor has no access to these arbitrage opportunities.
Do you have an example of this?
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Re: If trading is a losing game, how do you explain prop fir

Post by SumOfDivs »

Why should we assume that banks are run by smart people who know what they are doing? Why was Wachovia on the verge of collapse? Why did WaMu fail? If I were to say that the majority of businesses fail over the long run, would that mean no one should be in business?
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Re: If trading is a losing game, how do you explain prop fir

Post by DonCamillo »

One game played in HFT is to monitor small price discrepancies between markets, such as NY stocks and Chicago options. Buy the low price one, sell the high price one and collect the difference. With ultra fast computers, large quantities of stocks, trades hundreds of times a second, and extremely low trading costs, this can be profitable enough to pay millions for a communications link between NY and Chicago that is faster than the Internet.
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Re: If trading is a losing game, how do you explain prop fir

Post by Lodbrok »

boggler wrote:Many of these firms act as market makers
Most proprietary trading firms make money by making markets and collecting the bid-ask spread. Yes, they make money when regular investors trade, but it's by proving value to them rather than "taking advantage" of them. Being willing to buy and sell on today's very tight markets requires fast technology and infrastructure to lay off the risk absorbed when taking your trade.
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Re: If trading is a losing game, how do you explain prop fir

Post by matto »

nedsaid wrote:I suppose they take advantage of amatuers like us.
Talking to two finance friends of mine who have worked in big banks:

Me: "So you agree that it's essentially impossible for an amateur to beat the market, right?"
Them: "Yeah, the average joe should invest in index funds. If he/she really wants, they can do a lot of cash flow project analysis to try and identify undervalued stocks, but 99% the first one."
Me: "So what about prop firms and large banks?"
Them: "They can beat the market. Taking advantage of average joes, day traders, and each other. The things you can do with math PhDs, high frequency connections, and large computers give you a special edge."
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Re: If trading is a losing game, how do you explain prop fir

Post by Valuethinker »

matto wrote:
nedsaid wrote:I suppose they take advantage of amatuers like us.
Talking to two finance friends of mine who have worked in big banks:

Me: "So you agree that it's essentially impossible for an amateur to beat the market, right?"
Them: "Yeah, the average joe should invest in index funds. If he/she really wants, they can do a lot of cash flow project analysis to try and identify undervalued stocks, but 99% the first one."
Me: "So what about prop firms and large banks?"
Them: "They can beat the market. Taking advantage of average joes, day traders, and each other. The things you can do with math PhDs, high frequency connections, and large computers give you a special edge."
Wise advice.

There's some evidence hedge funds that employ Phds in finance outperform those that don't.
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Re: If trading is a losing game, how do you explain prop fir

Post by Call_Me_Op »

boggler wrote:The common wisdom here is that indexing is the best strategy over time.

But if this is true, how do you explain the existence of proprietary trading firms, which exist to trade their OWN capital?
Just because something is 'common wisdom" here, doesn't mean that everybody everywhere accepts it.
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market timer
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Re: If trading is a losing game, how do you explain prop fir

Post by market timer »

That's like saying, "If trading is a losing game, how do you explain Amazon?" There will always be middlemen who make money by facilitating trade, not by speculation.
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Re: If trading is a losing game, how do you explain prop fir

Post by Wagnerjb »

Prop firms may also make money by legally front-running others. One example in my industry (energy trading) is to front run the collateralized commodity futures (CCF) funds. Those funds - at least initially - would roll their futures on a certain date right before expiration. Once prop traders knew this, they front ran those trades.

We hear about front-running the stocks that are selected to enter or exit a large index. This seems more difficult than front running CCFs.

Best wishes.
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Re: If trading is a losing game, how do you explain prop fir

Post by richard »

market timer wrote:That's like saying, "If trading is a losing game, how do you explain Amazon?" There will always be middlemen who make money by facilitating trade, not by speculation.
Prop trading is trading for your own account, not acting as a middleman.
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Re: If trading is a losing game, how do you explain prop fir

Post by richard »

Wagnerjb wrote:Prop firms may also make money by legally front-running others. One example in my industry (energy trading) is to front run the collateralized commodity futures (CCF) funds. Those funds - at least initially - would roll their futures on a certain date right before expiration. Once prop traders knew this, they front ran those trades.

We hear about front-running the stocks that are selected to enter or exit a large index. This seems more difficult than front running CCFs.

Best wishes.
I would have thought the CCF funds would improve their strategy or most of the front running possibility would be arbitraged away as others catch on or both
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Re: If trading is a losing game, how do you explain prop fir

Post by KyleAAA »

Market making isn't investing by any reasonable traditional financial definition of the word. It's more like an operating business that sells liquidity. So yeah, market makers can do well using their institutional advantages, but they aren't investors in the sense we're talking about. And in any event the EMH, by definition, doesn't really apply to investors who literally have faster and better access to information than everybody else.
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Re: If trading is a losing game, how do you explain prop fir

Post by HomerJ »

richard wrote:
market timer wrote:That's like saying, "If trading is a losing game, how do you explain Amazon?" There will always be middlemen who make money by facilitating trade, not by speculation.
Prop trading is trading for your own account, not acting as a middleman.
But you are not buying and selling stocks based on fundamental values... you are buying from Joe and 0.03 seconds later selling to Harry for 1 penny more.

That's pretty much a middleman profit.
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Re: If trading is a losing game, how do you explain prop fir

Post by Wagnerjb »

richard wrote:
Wagnerjb wrote:Prop firms may also make money by legally front-running others. One example in my industry (energy trading) is to front run the collateralized commodity futures (CCF) funds. Those funds - at least initially - would roll their futures on a certain date right before expiration. Once prop traders knew this, they front ran those trades.

We hear about front-running the stocks that are selected to enter or exit a large index. This seems more difficult than front running CCFs.

Best wishes.
I would have thought the CCF funds would improve their strategy or most of the front running possibility would be arbitraged away as others catch on or both
Larry Swedroe says that the CCF funds have wised up, so they presumably roll their futures (sell the current month, buy the next month) at random times before the expiration date. But part of me thinks this move is only partially effective, because hedge funds know that CCF's will sell and buy around a certain time. I suspect you don't have to get the exact timing right to make a little money off their predictable buys and sells.

Best wishes.
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Re: If trading is a losing game, how do you explain prop fir

Post by zebrafish »

Dutch wrote:Insider trading, that's how I explain it
Ding, ding, ding. + infinity

There was a great episode of Frontline on PBS about this recently ("To Catch A Trader"). It did several things: 1) made me sick about how (some, but probably most) Wall Street traders, active mutual funds, and hedge funds operate, 2) made me believe that the individual investor is at a great disadvantage in purchasing individual stocks/securities, 3) further convince me that indexing/buy/hold is the only way for individual investors who are not inside-trading can reliably "win"
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Re: If trading is a losing game, how do you explain prop fir

Post by richard »

HomerJ wrote:
richard wrote:
market timer wrote:That's like saying, "If trading is a losing game, how do you explain Amazon?" There will always be middlemen who make money by facilitating trade, not by speculation.
Prop trading is trading for your own account, not acting as a middleman.
But you are not buying and selling stocks based on fundamental values... you are buying from Joe and 0.03 seconds later selling to Harry for 1 penny more.

That's pretty much a middleman profit.
That's high frequency trading, which is not the equivalent of prop trading.

Fundamental values? Are chartists middlemen?

How long do you have to hold not to be a middleman?
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Re: If trading is a losing game, how do you explain prop fir

Post by market timer »

richard wrote:
HomerJ wrote:
richard wrote:
market timer wrote:That's like saying, "If trading is a losing game, how do you explain Amazon?" There will always be middlemen who make money by facilitating trade, not by speculation.
Prop trading is trading for your own account, not acting as a middleman.
But you are not buying and selling stocks based on fundamental values... you are buying from Joe and 0.03 seconds later selling to Harry for 1 penny more.

That's pretty much a middleman profit.
That's high frequency trading, which is not the equivalent of prop trading.

Fundamental values? Are chartists middlemen?

How long do you have to hold not to be a middleman?
I took it OP was primarily referring to HFT.
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Post by pinecrest »

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Re: If trading is a losing game, how do you explain prop fir

Post by zeugmite »

EMH is folklore and true only in the limit of equilibrium (well, almost by definition true then). To you, who are slow and ungainly to see and act, the market appears in equilibrium all the time (except under extreme circumstances). To others who see and work with more detail, events happen constantly that drive things out of equilibrium, hence profits.
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Re: If trading is a losing game, how do you explain prop fir

Post by kenner »

zeugmite wrote:EMH is folklore and true only in the limit of equilibrium (well, almost by definition true then). To you, who are slow and ungainly to see and act, the market appears in equilibrium all the time (except under extreme circumstances). To others who see and work with more detail, events happen constantly that drive things out of equilibrium, hence profits.
Interesting.

To those of us who are "slow and ungainly to see and act", exactly what investments do you guarantee will outperform the stock market over the next 25 years.
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Re: If trading is a losing game, how do you explain prop fir

Post by rkhusky »

kenner wrote:
zeugmite wrote:EMH is folklore and true only in the limit of equilibrium (well, almost by definition true then). To you, who are slow and ungainly to see and act, the market appears in equilibrium all the time (except under extreme circumstances). To others who see and work with more detail, events happen constantly that drive things out of equilibrium, hence profits.
Interesting.

To those of us who are "slow and ungainly to see and act", exactly what investments do you guarantee will outperform the stock market over the next 25 years.
High speed traders do not care about long term performance. They do not care if a company will go bankrupt next year. They care if they can make a profit in the next few seconds to few days and they can react to market news in microseconds.
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Re: If trading is a losing game, how do you explain prop fir

Post by kenner »

rkhusky wrote:
kenner wrote:
zeugmite wrote:EMH is folklore and true only in the limit of equilibrium (well, almost by definition true then). To you, who are slow and ungainly to see and act, the market appears in equilibrium all the time (except under extreme circumstances). To others who see and work with more detail, events happen constantly that drive things out of equilibrium, hence profits.
Interesting.

To those of us who are "slow and ungainly to see and act", exactly what investments do you guarantee will outperform the stock market over the next 25 years.
High speed traders do not care about long term performance. They do not care if a company will go bankrupt next year. They care if they can make a profit in the next few seconds to few days and they can react to market news in microseconds.
I agree and I understand. Clearly the people who are trying to preserve American society.
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Re: If trading is a losing game, how do you explain prop fir

Post by zeugmite »

kenner wrote:
zeugmite wrote:EMH is folklore and true only in the limit of equilibrium (well, almost by definition true then). To you, who are slow and ungainly to see and act, the market appears in equilibrium all the time (except under extreme circumstances). To others who see and work with more detail, events happen constantly that drive things out of equilibrium, hence profits.
Interesting.

To those of us who are "slow and ungainly to see and act", exactly what investments do you guarantee will outperform the stock market over the next 25 years.
Equilibrium is considered as good, disequilibrium means somebody will turn out to be wrong, and being wrong is a risk, risk is compensated if you can be usually more right than wrong. That's why good market makers, who are by definition more right than wrong, are profitable. One way I think about long-term investing is that the only opportunity available to all people of ordinary skill -- the only disequilibrium or risk -- for which I can firstly see, and then reasonably believe myself to be more right than wrong about (although I only get one shot), is in the long-term dynamics of the economy whose profits are reinvested into the capital markets. This isn't a 'great' opportunity, honestly, compared to a wide range of other risks that can be exploited with skill, tools, access, what have you, and there is little edge one person over the next, but because of that, it is there for everyone. Why hasn't this opportunity been arbitraged away? Because the capital and time horizon required to do that are beyond the capability of any small group of people, though the use of leverage and events in recent years have made me question whether there is still any equity premium left.
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Re: If trading is a losing game, how do you explain prop fir

Post by boggler »

zeugmite wrote:
kenner wrote:
zeugmite wrote:EMH is folklore and true only in the limit of equilibrium (well, almost by definition true then). To you, who are slow and ungainly to see and act, the market appears in equilibrium all the time (except under extreme circumstances). To others who see and work with more detail, events happen constantly that drive things out of equilibrium, hence profits.
Interesting.

To those of us who are "slow and ungainly to see and act", exactly what investments do you guarantee will outperform the stock market over the next 25 years.
Equilibrium is considered as good, disequilibrium means somebody will turn out to be wrong, and being wrong is a risk, risk is compensated if you can be usually more right than wrong. That's why good market makers, who are by definition more right than wrong, are profitable. One way I think about long-term investing is that the only opportunity available to all people of ordinary skill -- the only disequilibrium or risk -- for which I can firstly see, and then reasonably believe myself to be more right than wrong about (although I only get one shot), is in the long-term dynamics of the economy whose profits are reinvested into the capital markets. This isn't a 'great' opportunity, honestly, compared to a wide range of other risks that can be exploited with skill, tools, access, what have you, and there is little edge one person over the next, but because of that, it is there for everyone. Why hasn't this opportunity been arbitraged away? Because the capital and time horizon required to do that are beyond the capability of any small group of people, though the use of leverage and events in recent years have made me question whether there is still any equity premium left.
Love this post.

What are some of the "wide range of other risks that can be exploited with skill, tools, access, what have you"?
kenner
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Re: If trading is a losing game, how do you explain prop fir

Post by kenner »

zeugmite wrote:
Equilibrium is considered as good, disequilibrium means somebody will turn out to be wrong, and being wrong is a risk, risk is compensated if you can be usually more right than wrong. That's why good market makers, who are by definition more right than wrong, are profitable. One way I think about long-term investing is that the only opportunity available to all people of ordinary skill -- the only disequilibrium or risk -- for which I can first see, and then reasonably believe myself to be more right than wrong about (although I only get one shot), is in the long-term dynamics of the economy whose profits are reinvested into the capital markets. This isn't a 'great' opportunity, honestly, compared to a wide range of other risks that can be exploited with skill, tools, access, what have you, and there is little edge one person over the next, but because of that, it is there for everyone. Why hasn't this opportunity been arbitraged away? Because the capital and time horizon required to do that are beyond the capability of any small group of people, though the use of leverage and events in recent years have made me question whether there is still any equity premium left.
Thanks for an erudite explanation. I agree with much of what you said. Perhaps there are some investors who can identify and profit from market price dislocations, but it seems that the great weight of evidence suggests that, over the long term, most investors fail in such a quest.
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Re: If trading is a losing game, how do you explain prop fir

Post by JoMoney »

kenner wrote: ... but it seems that the great weight of evidence suggests that, over the long term, most investors fail in such a quest.
Not just suggests, it's provable. The market doesn't produce anything more because people decide to trade or allocate differently. For those who decide to play the game of beating the market there can't be any more money on the "winning" (above average) side that isn't reconciled with "losers" (on the below average) side... and there will be even fewer "winners" because there are expenses that must be overcome for playing the trading game at all. The more transactions that occur, the higher the expenses, and the more likely previous winning choices will be averaged out with losers... you may get lucky guessing a coin flip from time to time but doing so consistently over time is near impossible... but maybe, just maybe, someone who is especially skilled at picking the right moments and not swinging at every pitch can get an edge with their careful choices... but even then the game is filled with heavy competition and only a few can win the prize and come out on top.
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Re: If trading is a losing game, how do you explain prop fir

Post by random_walker_77 »

DonCamillo wrote:One game played in HFT is to monitor small price discrepancies between markets, such as NY stocks and Chicago options. Buy the low price one, sell the high price one and collect the difference. With ultra fast computers, large quantities of stocks, trades hundreds of times a second, and extremely low trading costs, this can be profitable enough to pay millions for a communications link between NY and Chicago that is faster than the Internet.
And companies are willing to pay big bucks to get an edge here. Companies go to a lot of trouble and expense to shave 1/1000ths of a second off of network latency between chicago and new york or new york and london. How? By building more direct networks, or using more exotic technology:

http://www.businessweek.com/articles/20 ... d-of-light
http://www.ft.com/cms/s/2/2bf37898-b775 ... z2yKsnZDaw
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Re: If trading is a losing game, how do you explain prop fir

Post by keanwood »

DonCamillo wrote:One game played in HFT is to monitor small price discrepancies between markets, such as NY stocks and Chicago options. Buy the low price one, sell the high price one and collect the difference. With ultra fast computers, large quantities of stocks, trades hundreds of times a second, and extremely low trading costs, this can be profitable enough to pay millions for a communications link between NY and Chicago that is faster than the Internet.
This is off topic but the "communications link" is apart of the internet. It is not a separate thing even though it is much faster than what most people / business have access to.


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Re: If trading is a losing game, how do you explain prop fir

Post by avalpert »

boggler wrote:The common wisdom here is that indexing is the best strategy over time. Thus, trading stocks back and forth repeatedly, perhaps at high-frequency, is likely to underperform the market over time. Many Wall Street firms recognize this, but continue to trade because they are investing other people's money and thus get to charge a fee regardless of actual performance.

But if this is true, how do you explain the existence of proprietary trading firms, which exist to trade their OWN capital? (Many of these firms act as market makers or participate in HFT strategies, and many are quite profitable.) In other words, if those that know the most about the financial markets, know the theory behind indexing, and have the best access to the markets continue to trade, how can trading truly be a losing strategy? Or is it just a losing strategy if you don't have access to the resources of those firms?
What makes yo think most prop firms are actually beating the market return over time?

Trading isn't a 'losing' game in that you expect to lose money, you still expect to profit at the market return-costs. Prop firms can think they are doing a great job investing when they really are just average over time.

And of course providing services such as acting as a market maker has little to do with investing - you make a profit by providing the service for more than your costs.
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Re: If trading is a losing game, how do you explain prop fir

Post by bonglehead »

I think its fair to say that trading is a losing game for most people but there are exceptions though extremely rare. One such example is Jim Simmons of Renaissance Technology (a hedge fund) fame, he has NEVER lost money in his hedge fund and now I think his firm has returned all their clients' money and they just manage their own investments.

http://www.bloomberg.com/apps/news?pid= ... tory1.html

There might be few more people who have been so consistently successful but like I said earlier, its very very rare
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