Prop Trading Cheat Codes: DMAs
A little known cheat code that gives proprietary trading firms the extra leg up.
Proprietary trading firms, which include recognizable names like Jane Street and Hudson River Trading, are known for their ability to generate abnormal profits on in-house capital year-after-year:
While it is common knowledge that these firms exist and make money, very little is known about the behind-the-scenes quirks that make it all possible.
So, today we’ll take a look behind the scenes at one of these quirks, a “cheat code” if you will, that gives these firms a special leg up: Direct Market Access.
But before we can understand direct market access, let’s take a look at well, regular market access:
Traditional Market Access
To begin, let’s put ourselves in the shoes of a retail trader:
Your day job is at a copper mining company, so you know a good bit about the finer-points of the industry. You notice that today’s flow for Hudbay Minerals Inc. (NYSE:HBM) is abnormally negative compared to its peers. You have your ears-to-the-ground and know that this is likely a temporary mispricing due to any number of non-fundamentals (e.g., executive selling to buy a catamaran, pension fund rebalancing, etc.).
So, you submit a small order for 100 shares and begin the standard order process:
The stock isn’t traded heavily, so it will take some time for your order to get filled. But after a few seconds, you get your shares at a fair price, and all is well.
Whether you’re right or wrong, you later sell and go through the process again.
However, the above demonstration is generally optimistic and assumes that you are trading a very small size. Were you to trade in any larger size that could have an impact on others’ inventory or price, the broker is very likely to make an arbitrage on your order before it’s filled:
Now, let’s see how this same situation would play out on a proprietary trading desk.
Direct Market Access
As a proprietary trader, while you may not have the industry-specific expertise, you may have a model developed by a quantitative researcher on your desk that also indicates that Hudbay Minerals may be undervalued, so you also want to take a position.
Direct Market Access means that you bypass the broker since you are registered and have direct access to the exchange:
Even at a significantly larger trade size the trader at the prop firm is at a steep advantage. Because they have direct access to the desired exchange, their orders are filled almost instantaneously because they take liquidity straight from all orders pending or posted:
For example, if there is an ask price of $5.05 per share for 10,000 shares, they will buy it at that price and receive the full block immediately. No intermediaries, no routing — the open order just comes right off the book and is filled.
Further, it is easier for them to scale or de-scale the position since, due to their execution speeds, they can just trade away at the spread for all new incoming orders, possibly including yours:
For example, if they see increasing order flow to the stock (since they have access), they will unload some of their just purchased inventory at a slightly higher ask price, generating a small profit.
What’s The Difference?
This may not seem like a major advantage at first, but the retail trader in our example might make this trade once a quarter, where in that case, the slippage doesn’t really make that big a difference.
However, as a proprietary trader, you are taking trades like this every hour, every day. So, even tiny roadblocks like passing through a broker for a marginally worse price, rapidly compounds to make the difference between a big bonus at the end of the year and going out of business.
If this article piqued your interest, you’d definitely enjoy some of my other posts just like this one:
- You’ve Gotta See This Biotech Edge.
- Pub-stomping Option Markets with ARIMAX [Code Included]
- I Gutted The Entire Sports Betting Algorithm. [Code Included]
Happy trading! 😄
