[bogomipz]

Would you mind explaining what prop trading is? I am not familiar with this term.

From what I know of market making however is that you match a buyer and a seller of an asset, correct?

If I do have this correct about market making. Are they playing ask buy spread? Whose best interests is the market maker supposed to look out for? The buyers? The seller? Some combination therein?

[tedunangst]

The currency booth at the airport is a market maker. I give them dollars, they give me euros. They don't make me stand around and wait for a European to complete the trade, though. (That would be more classified as an exchange.) They are always willing to buy or sell at some price. The currency desk is mostly looking out for their own interest, but when I step off the plane, I want somebdoy to be there to sell me euros.

When George Soros decides to sell a billion British pounds, that's a prop trade. He's not hanging out letting the trades come to him.

(I say currency booth, not exchange, just to avoid confusion. We usually say exchange, because that's what happens, but it's not an exchange in the market sense.)

[bogomipz]

Great explanation, thanks. Exchange does seem to be a of a misnomer, agreed.

[FabHK]

Trading desks can make money in three basic ways: 1. Buy low, sell high. 2. Manufacture a product and sell it, taking a cut. 3. Take a view on where the price is going to go, then take a position accordingly.

1. is basically market making. You can either wait until you have a matching trade and take a cut (=exchange, broker). Then you're always flat (that is, you don't care where the price moves - you always get your cut). Or you can post bid and ask at which you are prepared to trade. When someone avails themselves of this, you then have a position, and the market might move against you. The spread compensates for that risk. Key here is to distinguish informed traders (that offload stuff on you before the price drops due to some news) from "dumb money", aka noise traders, that just want to buy or sell some stuff, but don't have information where the price will go. The latter make you money on average, the former might cost you.

2. That's basically manufacture of derivatives, say. You buy or sell an option, charge something on top of the computed price, and then trade underlyers against it to be flat, and at the end ideally realise that charge.

3. This is basically prop trading. If you put on the proper position, and your view turns out right, you make money, otherwise you lose. You need to be right more often than wrong :-) and quite some capital cushion to balance out the wins and the losses.

So, prop trading is characterised by you NOT being flat, i.e. you are exposed to market moves. As someone pointed out, when you are market maker, you are also exposed, but it's for short periods of time, and not the main goal. However, this does introduce some ambiguity.

[branchless]

Market making you provide a buy and a sell price and keep the spread for your "service".

Prop trading: you buy or sell based on a guess which way things will go and hold that position then exit at (you hope) a profit.

Normally the big book of banking says market makers "provide liquidity" which in my experience is enough to make most people in banking stop right there as providing liquidity is to them akin to passing bread to orphans.

[chris11]

Also, prop traders use the firms money to trade, they don't use client money. So the firm is responsible for the loss and gets the benefit of the profit.

[branchless]

Market making also uses firm money but the net position is (hopefully) flat. They trade against someone when their order matches on the exchange.

[bogomipz]

Thanks, question:

"as providing liquidity is to them akin to passing bread to orphans."

I'm not following your meaning there. Meaning?

Also, is every brokerage also a market maker?

[frandroid]

Brokerages pass on trades to market makers. They don't promise a price, they just tell you which price is available through market makers, and when you decide to go ahead with a trade, they go on the market, and you hope that the price market makers were advertising earlier is still what they're offering when you come through. Brokerages make a profit by passing on your order and taking a percentage of your total sale, not by making a profit on the spread.

[branchless]

I just find that whenever anyone wants to justify a total waste of resources like some people using microwaves to shave a micro off to nickle and dime the world it always comes down to some guff about liquidity to defend it.

The arms race where you never get to zero.

[nerdponx]

Providing liquidity is a service, so institutions expect to be paid for that service