Trading derivatives as a prop trader is a whole different ball game. As a prop trader you use the futures prop firm’s capital to make trades, profit from winning trades and not lose your personal money.
Deciding to trade derivatives should be based on a deep understanding of these instruments and the high risk-reward ratio.
Before trading derivatives in a prop trading environment, consider how deep your market knowledge is and how well you can handle and manage risk.
Derivatives are often leveraged, meaning they can magnify both gains and losses. Your experience with trading strategies, market analysis and comfort with big volatility are key in determining if prop trading derivatives is right for you and your financial goals and risk tolerance.
In addition to personal competence, access to advanced trading tools and robust risk management systems from your prop trading firm can be important in trading derivatives.
These tools can help you develop a trading plan, so you can react fast to market changes and maximise your profitability.
Now that you’ve considered the risks, make an informed decision about derivative prop trading.
Derivative Instruments
Before you enter the world of derivative instruments as a prop trader, you need to understand what they are, how they are traded and the balance of risk and reward they carry.
Definition and Types of Derivatives
Derivatives are financial contracts whose value is based on underlying assets like stocks, bonds, commodities or currencies. The most common types of derivatives are:
- Futures: Agreements to buy or sell an asset at a specific date and price.
- Options: Contracts that give you the right but not the obligation to buy or sell an asset at a specific price on or before a certain date.
- Swaps: Agreements to exchange cash flows or other financial instruments.
- Forwards: Customised contracts between two parties to buy or sell an asset at a specific price on a future date.
How Derivatives are Traded
Trading derivatives involves understanding:
- Leverage: Control large positions with a small amount of capital, magnify both gains and losses.
- Margin Requirements: You need to deposit a fraction of the total trade value, known as margin, which varies depending on the derivative and market volatility.
- Mark-to-Market: Derivative contracts are often revalued daily which can impact margin requirements.
The trading venue is:
- Exchanges: Standardised contracts are traded on regulated exchanges, more transparency and lower credit risk.
- Over-the-counter (OTC): Customised contracts are traded between parties without an exchange.
Risks and Rewards
Derivatives trading involves:
Risks:
- Market Risk: Losses due to asset price movement.
- Liquidity Risk: Some derivatives, especially OTC, can be illiquid.
- Counterparty Risk: The risk the other party defaults.
Rewards:
- Hedging: Using derivatives to protect against asset price movement.
- Speculation: Big profits from small investments with leverage if market is right.
- Arbitrage: Profiting from price difference of same assets in different markets.
While the rewards are big, they come with a level of risk that requires understanding and risk management.
Proprietary Trader
In prop trading you make direct trades to generate profits for the firm using a specific skill set in a highly regulated environment.
Prop Trader Responsibilities
- Market Analysis: You need to analyse market trends to find trading opportunities.
- Risk Management: Manage the risks of trading to protect the firm’s capital.
Prop Trading Skill Set
- Analytical Skills: You need to analyse financial markets and economic indicators.
- Decisive Action: You need to be able to act fast under pressure to trade opportunities.
Regulatory
- Compliance: You need to comply with laws and regulations, such as the Volcker Rule, to avoid conflict of interest between the firm and its clients.
- Due Diligence: Thorough due diligence to ensure trading is legal.
Derivatives Trading Strategies
When trading derivatives, you need a strategy to navigate the complexity and manage risk. Here we’ll look at three strategies: Fundamental Analysis, Technical Analysis, Quantitative Strategies, each a different way to view and trade the market.
Fundamental Analysis
Fundamental Analysis is about evaluating the economic and financial factors that can impact the asset price. As a prop trader you look at macroeconomic indicators such as GDP growth rates, inflation, employment data and company specific fundamentals like earnings, financial health and management efficiency. For derivatives like futures and options, understanding the intrinsic value and time value can help you determine the real value of these instruments.
Technical Analysis
Technical Analysis is about statistical trends gathered from trading activity, such as past prices and volume. You’ll use various chart patterns and technical indicators like moving averages, Relative Strength Index (RSI), Bollinger Bands to predict price movements. This will help you decide on entry and exit points and identify potential short and long positions for derivatives trading.
Quantitative Strategies
Quantitative Strategies is about applying mathematical models to find trading opportunities. You’ll use historical data to build algorithms that can see patterns or trends that are not visible to the naked eye. Backtesting will be used to test these models thoroughly before you trade. In prop trading, quantitative strategies are preferred because they are systematic and can remove emotional bias from trading decisions.
Market Conditions
Understanding market conditions is key to your success as a prop trader in derivatives. Economic indicators, market volatility and liquidity can make or break your trades.
Economic Indicators
Economic indicators are key signals that give you insight into the state of the economy and impact your trading decisions. GDP, unemployment rates and inflation figures can show economic trends that affect market sentiment and therefore the value of derivatives. For example a rising GDP might be bullish, increasing unemployment might be bearish.
Market Volatility
Volatility in the market can impact how you trade derivatives as it represents the frequency and size of price movements. The VIX index measures the market’s expectation of volatility which can guide your strategy; higher volatility means higher potential gains but also higher risk.
Liquidity and Time Horizons
Liquidity or the ability to get in and out of positions is key, especially for short term trades.
Highly liquid markets means quick trades with minimal slippage.
Look at the trading volume and open interest of the derivative instruments to gauge liquidity.
Your trade horizon must align with these liquidity considerations.
Longer term means less liquid markets, short term means high liquidity.