NuclearPhynance Archive

I am used to hedge fund style payouts (2% and 20% etc), and am trying to understand a prop trading deal that I have been told is pretty typical.



The deal is you put up some Minimum Trader Equity (MTE), and the firm puts up 9x your capital. They then lever that up 6 times. The trader then gets 33% of PnL on the gross amount.



So for example, on a 100K MTE, the firm brings 900K and levers the 1M up to a 6M book. On a 1% pnl, the trader takes (or eats) 33%, so 20K. If a 1% loss is 20K, isn't the trader effectively levered 20x on their money? Why would anyone take this deal if a 5% drawdown will blow them up? Just hope that it doesn't happen? Or just no better hedge fund deals (1 and 10 etc) available?

thanks

So there are a few considerations here:



1. Minimum account size considerations: You could open your own account, but 100,000 USD may be below the minimum account size for many brokers (depending on what you are doing).



2. There are funding considerations. For example, if you are trading cash instruments (say: equities) then the leverage financing available to you is maybe 7x, regardless of the volatility of your portfolio. That's just the most of Prime Broker will typically extend to you (and in some cases less). This allows you to take leverage of essentially 10 x 6/3 =20x. If your volatility is low (e.g. your Sharpe Ratio is high), this may make sense.



3. You may not find a 1% and 10% deal.



4. Finally, what makes you think that a 5% drawdown won't get you fired at your typical hedge fund? Many hedge funds operate with maximum drawdown limits of 5% or so per trader.

>4. Finally, what makes you think that a 5% drawdown won't get you fired at your typical hedge fund? Many hedge funds operate with maximum drawdown limits of 5% or so per trader.



I know you say many, but is this for a subset of strategies?

The other common structure these days is bonus escrows. (Your first M goes into escrow to "protect" against future losses)



There are a lot of coin flippers out there

Like FDAX said, if your Sharpe ratio is high, then the drawdown risk is de minims. 33% > 20%, so why wouldn't you want to take home more money.



The other dimension is that usually prop groups have exchange memberships, clearing arrangements or trading infrastructure better suited for HFT-type strategies than hedge fund seeders. Low fees and fast execution can literally make or break the viability of many strats.

Thanks for the replies.



It sounds like FDAX's points 1,3 speak to people just not having any better options (I would say that in point 4 I'd rather be fired for a drawdown then lose my investment).



EspressoLover and FDAX also point out that if your Sharpe is high enough, such a drawdown would be unlikely and such leverage would be worth the additional payout. The couple of guys I spoke with in these types of deals seemed unfazed at having their equity wiped out; and in a few cases this was a fairly frequent event (every 2 years) but the firm let them keep trading to try and dig themselves out of the hole.



My suspicion is that a minority of people in these prop deals do so because of their high Sharpes, and more are in it because no better payouts are available - they are desperate to trade. What do you guys think?

@guy -- I mostly agree. I'd generally never sign such a deal. (As a high sharpe HFT-er)



I think fair value moves around quite a bit in these deals though.