I've been an options market maker and discretionary commodity trader with a broker/dealer for the past 5 years. Here's a breakdown of how professional traders earn a consistent living:
Market Making – These traders act like a casino, hoping to profit regardless of what happens. By constantly showing bids and offers, they collect the bid/ask spread. Being a good market maker is about identifying when someone has information and avoiding getting run over (e.g. not taking the other side of "smart money".) There are frequently economies of scale in market making as groups of traders can profitably pool and offset their risk. Occasionally, market makers will take discretionary positions when they see great opportunities. Market making in each asset class is dominated by a handful of big players who have the capital, expertise, and number of traders to take on the most risk for the least profit.
Options Market Makers: Options market making is viewed as an ongoing activity and traders are rarely totally flat. They will take the other side of an options trade and hedge their delta (i.e. exposure to the underlying stock or commodity), but they generally retain at least some volatility or skew risk. Options market makers stream their quotes to exchanges and/or show markets to brokers.
Equity Market Makers: 10 years ago this was a thriving business, but now that stocks are priced in penny (or sub-penny) increments, it has become dominated by black box programs. Quantitative traders create computer programs that trade millions of times a day, collecting fractions of a penny each time.
Fixed Income Market Makers: Because of the large amounts of capital needed, these guys tend to trade for the biggest banks and hedge funds. The bid/ask spreads are quite wide and the markets are relatively illiquid. Trading is done mostly through brokers.
Quantitative Trading – This is a broad category. The key theme is an emphasis on identifying market inefficiencies using statistics. Consistent profits come from having the fastest software, the best programming, or the savviest statistical analysis.
Arbitrageurs – A handful of firms with the fastest software and hardware earn outsized profits by exploiting true arbitrage opportunities (e.g. trading a stock or commodity that is listed on multiple exchanges but trading at different prices.)
Statistical Arbitrage – These traders identify patterns in the market, frequently with data mining software. For example, they may find that stocks in Asia follow stocks in Europe, but with an exploitable lag. These traders may exploit the inefficiency with manual click trading or with computer programs.
Black Box Trading – This can involve statistical arbitrage, but is defined by the lack of manual involvement. The trader creates a computer program and sets it running and generally stays out of the way. Black box trading covers most asset classes and time frames, but particularly excels at exploiting short-term inefficiencies faster than a human could possibly click. Gray box trading is similar but implies greater human involvement.
Discretionary Trading – Another broad category that consists of market takers who execute their trades manually.
Technical Traders – Traders that rely solely on technical analysis are rare at large banks and hedge funds because they have difficulty producing consistent returns. Technical analysis includes charting as well as computer driven quantitative measures. The best technical analysts seem to have an intuitive feel. Trades are executed manually, otherwise, the trader would more accurately be considered a quantitative trader.
Order Flow Traders – These traders attempt to exploit patterns in customer order flow. While this approach can overlap technical analysis, since both are ultimately trying to divine what the rest of the market will do, order flow traders rely on specific knowledge. For example, this trader may know that options market makers in sugar will be inadvertently getting short sugar due to monthly options expiration, and are thus likely to buy sugar futures on a specific day. The order flow trader will exploit this knowledge to buy sugar futures in advance.
Fundamental Traders – These traders focus on analyzing a product with a specific catalyst, to avoid locking up their money for too long. They may have a strong understanding of what a specific earnings announcement means for a stock and will be among the first to buy or sell the stock to the appropriate level after the news is released. They may trade illiquid products with expiration dates, like electricity or lumber futures. With a deep understanding of a product, they bet on temporary mispricings and profit when the market corrects, or when the contract settles.
Execution Trading – These traders execute orders on behalf of customers and generally collect a per unit commission. For example, a pension fund may want to buy a huge quantity of Microsoft shares. If they buy the shares carelessly, they will have excessive market impact and pay too much for the shares, so instead they outsource the order to a broker/dealer for execution; a talented trader will minimize the market impact and get the best possible price with a knowledge of market microstructure.
Execution traders may act purely as a broker and work the order in the market, or they may also provide liquidity and act as a dealer, in which case they can be considered a market maker. To have a career as a professional trader, you need a consistent edge on the market. Usually that edge consists of being part of a brand name institution that gets customer order flow, has competitive software, or low latency connections to exchanges. Occasionally it can mean having a deep understanding of a product, sector, industry, or knowing the habits of other market participants.
Professional traders expect to generate a return on capital of anywhere between 8 and 100% annually, depending on the risk and how well the strategy can be leveraged.
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