“How much are you up this year?” Ummm, in investment management you can usually answer this question without hesitation. In prop trading at a broker-dealer, this is a much harder question to ask without crossing into dollar amounts. Which is slightly awkward, it’s like asking someone at a cocktail party what their salary is, a cringe worthy question. To compound the difficulty, my capital was increased a number of times making percentage calculations a mind numbing conversation.
At a prop firm such as ours, there is a big pool of capital that is then leveraged and in essence shared among all the portfolio managers and you are assigned various risk metrics. To simplify all the rules, you are assigned a “box size”. And all the metrics are more or less a percentage of this amount. But that is not actually the CAPITAL you are given. The actual capital is somewhat nebulous, and it can be shifted and transferred among the pool at any time. It would be similar to how the old Investment Bank prop desks ran where capital was basically unlimited but risk was not. They called it VAR and we called it draw down but similar concept.
So I went about calculating my performance to answer this vexing question which I knew was going to continue to come up. So after some thought I considered 2 methods of calculation:
1) Return on Equity – Since we can assume that a 10% draw down of your box will result in termination, we know there is an equity figure where you will be kindly asked to close all positions and meet someone in the conference room. Remember to pack ahead! For example, if you have a $5MM box, you can assume that if you are down $500k (10% draw down) that you will be shown the door. Similarly if you ran your own money, once your account goes to $0.00 you are done. So this is approximately the equity one would need to maintain in the account to absorb losses in a leveraged environment or “first-loss” capital.
2) Return on Overnight Capital – Although you are given in the example $5MM, this is only intra day capital. We were limited to 50% of the box overnight, being that I am an overnight trader I believe using the overnight capital account makes sense as well. In a non-leveraged account this is the amount of capital I would need to hold my positions. I probably only bumped into this number on a handful of occasions when trading common stock positions.
Another metric that might be useful is return on maximum margin utilized but unfortunately I do not have that data.
I also feel that performance needs an adjustment for costs. At ~.01 per shares and $1 per option contract, plus pass through charges, plus desk fees, plus LIBOR+1.25 on financing and receiving no short rebate, our costs were well above what could be expected at any other place except perhaps another prop trading shop.
Lastly, I calculated the Sharpe Ratio. It’s pretty easy to see the return percentage basically is a function of the denominator you decide to use but how about the shape of the curve? Another question with a non trivial answer, at a prop trading operation since one doesn’t receive any interest from cash balance, should I subtract the “risk free” rate of return? I utilized 2 different risk free rate of return, both the 13 week and the 10 year. It turns out that since the return on 13 week T-Bills is basically 0 it is similar to taking it out.
|Sharpe Ratio||At Cost||Commish Adj|
|13 week T-Bill||1.23||1.23||1.39||1.39|
|10 Year Treasury||1.17||0.92||1.09||1.33|
Looking at the shape of the equity curve, I obviously had some draw down periods but overall the curve is trending up and to the right. Each “event” I took as a learning opportunity and have made strides in adjusting my strategy. These events were easily identified in retrospect but were mostly due to human error in overriding the general system. As my account size grew it was easier to structure trades and still reach desired absolute returns. I hope to write more on this soon!
If anyone was curious on the state of the job market, there are opportunities to trade capital however the ‘strings’ attached are more onerous (fees, payout, risk tolerance etc are very skewed towards capital provider) I have been pursuing positions outside of typical front office roles and that has been extremely robust, especially manager selection and hedge fund research. Surprisingly so in fact. Finally, this blog and twitter have been phenomenal resources and the outreach has been wonderful so thank you and Happy Holidays to any and all readers!