As day trading gets more popular, the number of ways for making money in the sector is constantly growing. In this regard, many people opt for running their personal accounts using retail trading platforms like Robinhood and Webull.
Others decided to start their own day trading business by relying on proprietary trading firms, while some others joined hedge funds to develop their careers.
In this article, we will look at these two other options that you can use and their differences and similarities: prop trading and hedge fund.
What is prop trading?
Proprietary trading, popularly known as prop trading, is a fast-growing concept in the financial market. There are two main ways to look at prop trading. First, it involves a process where a company trades financial assets like commodities, crypto, and shares internally without using external funds.
Another popular definition of prop trading is where a company provides funds to different traders (The buying power) and then takes a cut from the profits. In most cases, these firms take between 10% and 20% of the total profits generated by traders.
Prop trading firms provide mutual benefits to the participants. The firm makes money from a wider pool of traders while traders receive more funds to trade. Some of the most popular prop trading firms are Real Trading, The 5%ers, and FTMO among others.
How prop trading works
The concept of prop trading is relatively simple to understand. It involves two main parties: the company and the traders. The company develops the trading platform, terms and conditions, and the broader onboarding process.
After this, potential traders can create their own accounts, learn the process and take part in a real demo trading environment for a while. After this, if they are successful, they can get funded by the company and then they start trading.
The trader’s revenue will come from the profits they generate in their accounts. The company will always take a smaller cut in order to incentivise the traders.
Real Trading goes the extra mile, where it encourages its floor managers to add more people to their trading floors.
Key characteristics and objectives
There are several characteristics of prop trading. First, in most cases, prop trading firms operate online, where everything is done through the internet. For prop trading firms like Real Trading, people sign up online and then report to their account managers using popular communication channels.
Second, the prop trading firm provides education to traders. In most cases, prop trading will provide some basic education packages to their new traders. They teach them how to use their platform and how the trading process works.
Third, these firms take a cut of their trader’s profit. This is their business model. Fourth, prop trading firms have severe risk management strategies to prevent significant drawdowns.
Some of the most popular risk management approaches are using stop-losses, avoiding huge trades, and closing all trades overnight.
There are other characteristics of prop trading. For example, in some cases, these firms recommend their own proprietary trading strategies and they also have unique trading tools.
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Advantages of prop trading
Prop trading has numerous advantages, including:
- Capital – Using a prop trading firm will give you access to more capital than you would in a retail account.
- Coaching – Prop trading firms profit when traders are making money. Therefore, they provide coaching to ensure that their traders are profitable.
- Trading floor – It is difficult to create a trading floor with a retail account. Prop trading firms make it easy to do this.
- DMA – In many cases, prop trading firms will provide you with direct market access when trading.
- Higher profits – Since you are using more trading capital, prop trading firms give you the ability to make more profits.
- No external investor pressure – As a prop trader, you don’t have a lot of pressure from external investors.
What is a hedge fund?
A hedge fund is a financial institution that invests or trades assets like shares, bonds, commodities, and currencies. These funds manage money for other people or companies.
In most cases, the main customers of hedge funds are high net-worth individuals, pension funds, and other institutional investors.
Hedge funds make money in two ways. First, they take an administration fee, often 2% of the total assets. Second, they take an incentive fee, which is often between 10% and 20%.
So, assume that a $1 billion fund makes a 20% return in a year. In this case, its revenue will be 2% of $1 billion, which is $20 million. The incentive fee will be $60 million if they take a 20% cut.
Hedge funds manage over $2 trillion. Some of the most popular hedge funds are Bridgewater Associates, Pershing Square Capital, Man Group, and Renaissance Technologies.
How hedge funds work
A hedge fund is a company that raises funds from external investors and then promises them uncorrelated returns. The concept behind this is simple. If you are an expert in trading and investment, you can lure people to invest in your firm. Then you will give them a cut of their profits.
A hedge fund is always associated with its founder. In this case, Pershing Square is associated with Bill Ackman while Bridgewater is associated with Ray Dalio and Citadel is associated with Ken Griffin.
Key characteristics and objectives
The main objective of hedge funds is to generate uncorrelated returns that often outperform the broader market.
The key characteristics are:
- They raise money from a wide group of investors, who include pension firms and sovereigns.
- These hedge funds focus on one or more strategies. Some of the top strategies are long only, short only, macro, quantitative, and long-short.
- Hedge funds have a small team of professionals. Most funds have less than five employees while big ones like Citadel have thousands.
- In the US, these funds must always deliver several disclosures to the SEC. One of these disclosures is their portfolio holdings. Further, these firms benefit from the carried interest loophole.
Advantages of hedge funds
- Flexibility on strategy – These firms are more flexible in how they allocate funds in the market.
- External investors – Hedge funds can be bigger than prop trading firms especially if you have a high profitability ratio.
- Higher returns – In some cases, these hedge funds have the ability to generate higher returns. Besides, they can attract higher experienced talent.
Similarities between hedge funds and prop trading firms
As seen above, hedge funds are different from prop trading firms. Nonetheless, the two have some important similarities, including:
- Profits-oriented – Prop traders and hedge fund managers are more profit-oriented. Their goal is to become highly profitable.
- Risk-taking – The two participants rely on risk-taking to generate profits. In most cases, they increase their profit potential using leverage.
- Strategies – In some cases, these prop trading firms and hedge funds use similar strategies to generate returns. Popular strategies applied by both are trend-following and reversals.
- Similar assets – These firms trade similar financial assets like stocks, currencies, cryptocurrencies, and bonds.
- Finally, these firms contribute to market efficiency by providing liquidity to the ecosystem.
Differences between hedge funds and prop trading firms
There are numerous differences between a prop trading firm and a hedge fund. Let’s dive into some of the top differences.
Source of funding
One of the top differences between the two is the source of funding. Hedge funds source their funds from external investors while prop firms use internal funds.
Hedge funds raise capital from players like pension funds and high net-worth investors.
Regulations
Hedge funds must follow stricter regulations since their investors are pension funds. For example, a pension fund like Calsters owns funds from California teachers.
Prop trading firms are less regulated. This does not mean that it has no obligations to follow, but they are less compulsory.
Profits and losses
Both companies are able to make losses because the market does not always work as predicted. When a prop trader makes a loss in a month, they don’t make any money.
On the other hand, a hedge fund can still make money when they make a loss because of the administration fee.
Horizon
Most prop trading firms are focused on short-term day trading activities. Hedge funds, on the other hand, focus on identifying assets and holding them for quite some time. Some of them hold stocks for years.
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Accountability
Hedge funds have more challenges since they report to their investor base. On the other hand, prop trading firms can easily drop an underperforming trader.
Prop trading vs hedge funds: which is better?
A common question is on which option is better between a prop trading firm or a hedge fund. In our view, we believe that prop trading is better for most people since it is easier to join an already-established firm.
Getting into a hedge fund or creating yours from scratch is not easy. For example, getting employed in a hedge fund is more difficult since these companies rely on highly-experienced individuals. Also, raising hedge fund capital is an extremely difficult process.
Further, hedge funds are more regulated than prop trading firms and you are not answerable to external investors.
Conclusion
This article has looked at the concept of hedge funds and prop trading. We have seen that hedge funds rely on external funding while prop trading depends on internal funds.
Also, the article has identified the unique characteristics and advantages of each process. Most importantly, we have seen that prop trading is a better option for most people.
External useful resources
- How Do Hedge Funds Make So Much Money? Best Business Model In The World – Financial Samurai
