The Prop

Traders
Chronicles
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 The Prop
Traders
Chronicles
Short-Term Proprietary Trading
Strategies for Both Bull and
Bear Markets

FRANCIS JAMES CHAN

John Wiley & Sons, Inc.

Cover image: Cover Design: Wendy Mount
Cover Illustration: 
C Rob Porazinski

Copyright 
C 2013 by Francis James Chan. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data

Chan, Francis James, 1982

The prop traders chronicles : short-term proprietary trading strategies for both bull and
bear markets / Francis James Chan.
p. cm. (Wiley trading series)
Includes index.
ISBN 978-1-118-24108-0 (cloth); ISBN 978-1-118-28296-0 (ebk);
ISBN 978-1-118-28416-2 (ebk); ISBN 978-1-118-28468-1 (ebk)
1. Stock brokers. 2. Stock exchanges. 3. Stocks. 4. Speculation. 5. Capital market.
I. Title.
HG4621.C423 2012
332.63 22dc23
2012022851

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1
To my friends and family, who supported me
on the roads less traveled.
 Contents

Preface ix

CHAPTER 1 Eat a Percentage of What You Kill 1

CHAPTER 2 A Swift Reality Check 9

CHAPTER 3 The Basics of Double Auction

Markets in the Real World 21

CHAPTER 4 Introduction to the ECN Platforms

and Order Routing 29

CHAPTER 5 Dark Pool Liquidity and Alternative

Trading Systems 41

CHAPTER 6 Combining Level 2 and Time &

Sales: Reading the Consolidated
Tape 47

CHAPTER 7 Week One on Live Trading 55

CHAPTER 8 Losing $30,000 in Under a Minute 71

CHAPTER 9 Trading with a Real Edge 79

vii
viii CONTENTS

CHAPTER 10 The Psychology of Profitable

Trading 91

CHAPTER 11 Choosing a Proprietary

Trading Firm 107

CHAPTER 12 Strategy Diversification 117

CHAPTER 13 Volatility and the Crash of 2008 127

CHAPTER 14 Building Blocks of Trading

Strategies 133

Glossary 141

About the Author 149

Index 151
 Preface

hat do you do for a living up there in Canada?

W The United States border official began his questioning while he

examined my Toronto-issued passport. He was devoid of the
type of smiles and overall casual, easy-going personality I had (surprisingly
to many) come to expect of others in his profession. It was 2007, well into
the post-9/11 world of Homeland Security. And I had encountered quite a
few of his colleagues at the Niagara Falls border, having frequently traveled
to New York to visit my ex-girlfriend. I am and have always been a fan of
that city and, unsurprisingly, it continues to play a significant role in both
my personal and professional life.
Im a trader, I answered.
A traitor? The bald man asked, having clearly enunciated the second
t without showing so much as a hint of a smile if doing so was even in his
repertoire.
I trade stocks for a proprietary trading firm.
What kind of stocks are there to trade, up there in Canada?
I only trade NYSE listed stocks right now, actuallyat a firm in
Toronto. I had nothing against the Toronto Stock Exchange, but it just
happened that I specialized in a style of high-volume ECN rebate trading
on New York listed equities that was mostly impossible to duplicate on the
TSX at the time.
Got any stock tips for me? He looked up as he posed the question
and watched my facial cues as if to test the legitimacy of my claim.
Mostly just scalp AMD latelyyou know, the Pepsi of PC processor
chips to Intels Coca-Cola. Obviously, the references had gone well over
the border officials head.
Thats it? You just trade one stock all day? He raised an eyebrow.
In reality, I switched between a small basket of stocks at the time, but
a simple yes sufficed. Needless to say, the usual okay, go ahead with a

ix
x PREFACE

welcoming smile after two seconds of questioning, which in my experience

was typically offered to Canadians who answered two or three questions
at the U.S. border without much hesitation (yes, even in 2007), was not
about to be offered this time. Instead, the man asked to see the contents of
my wallet and spent the next 10 minutes going through every single item.
Naturally, he closely examined a business cardthe one from my floor
manager at the Toronto-based proprietary trading firm (or prop firm for
short) where I worked at the timeand analyzed it as if it were a piece of
vital evidence in a crime scene investigation. Eventually, after meticulously
inspecting each and every item in the wallet, he nonchalantly handed all of
my credit and debit cards, ID cards, passport, and U.S. cash back to me in
a mound. I was forced to reassemble the hill of plastic and paper into the
wallet before proceeding into Buffalo, New York.
After the unfortunate events of September 11th, 2001, which had led
to increased border security, Canadians were, for the first time, treated by
American border officials as foreigners at the Niagara Falls border (prior
to 2001, a verbal confirmation of citizenship was all that was typically re-
quired for a Canadian to pass; no passport, nothing). As of January 2007,
it was also required to present a passport to enter the United States by
air, with other forms of transportation to follow. Yet even then, it was typi-
cally a much more straightforward process than that one particular, unusu-
ally humorless, American border official had decided to make his job. In
fact, his unusually unfriendly demeanor had reminded me that the typical
American, in my experience, tends to be much friendlier and more per-
sonable than the overplayed stereotypical contrasts between residents of
the two countries would suggest. He had also reminded me that miscon-
ceptions and general ignorance about prop firms, and markets in general,
remain as widespread as ever in a time when politicians feel free to use
investor protection as a public catchphrase to appeal to the lowest com-
mon denominator; and as an excuse to pass arbitrary laws and regula-
tions based on unproven theories that do little more than protect securities
lawyers from boredom.
Over the years, I had also found that there was an excellent variety of
books available on all aspects of the finance industryranging from the
entertaining tales of Michael Lewiss Liars Poker to Nassim Talebs philo-
sophical treatise, Fooled by Randomness. Yet, I couldnt help but notice the
rarity of published material that accurately conveyed the multifaceted sub-
tleties of modern tape reading and destination selection often employed
at todays proprietary trading firms and institutions. The basic and very
Preface xi

practical skills of reading the tape, and selecting an optimal market center
or dark pool algorithm for an order, should be learned and honed not only
by high-volume scalpers and frequent day traders but by many other styles
of traders and investors looking to optimize the cost of entry and exit.
In an industry that revolves around making money, and minimizing
costs, it astounded me that articles continue to gloss over concepts like
ECN pricing and rebates with choices of wording that make it abundantly
clear that the authors have no concept of this aspect of the industry or its
accepted standards.
While retail participants were traditionally excluded from the ability to
interact directly with the equity exchanges, ECN systems, and dark pool al-
gorithmic routes, a growing number of todays deep discount direct access
brokerages enable individual traders to join this institutional poker table
and participate directly on the playing field traditionally reserved for pro-
fessional proprietary traders and HFT computer systems. These, and other
vital elements of trading and strategy development, are often taught in
the training programs conducted at proprietary trading firms that trade on
the U.S. equity marketswhether the firm itself is operated from Toronto,
New York, London, or anywhere else in the world where acceptable latency
can be achieved via Internet connectivity to Wall Street. (More accurately,
connections are actually made to the U.S. exchanges computer systems
located in an Equinix data center in New Jersey that currently houses the
NASDAQ, Direct Edge, and CBOE exchanges.)
More importantly, politicians who deliberately cater to voters who they
assume do not understand the first thing about basic concepts of the secu-
rities marketslet alone the practical function and benefits these concepts
may provide to traders and investors of all kindswill hopefully lose some
of their support in passing superficial regulations. If the general trading
and investing public is given an opportunity to gain a better understand-
ing of the electronic markets, maybe the debates over the merits of many
aspects of a free market could be better understood rather than used for
shallow, emotionally targeted arguments. Ideally, a better educated public,
particularly with more education on the real-world effect of actions such as
short selling (and the subsequent buying that is required to take profits or
cut losses in such a position), would be able to defend against the sorts of
political agendas that rely entirely on knee-jerk short-term memory based
reactions out of pure mass ignorance.
Whether youre an intermediate trader looking to learn more about
the basics of proprietary trading firms or an individual investor looking
xii PREFACE

to better understand the basics of todays electronic trading systems, Ive

attempted to weave important concepts and practical lessons into the sto-
ries and anecdotes into the story of the beginning of my career, and sub-
sequent personal growth, as a trader. This book was not intended to be
an instruction manual or a simple strategy guide, but rather a narrative of
one traders experiences in one corner of the much larger global securities
trading industry.
Many individuals names, and the names of a few legal entities, have
been changed to protect the privacy of current and former colleagues and
peers. Of much greater importance is that the core lessons and experi-
ences, told from the perspective of one proprietary trader who participated
in the equity markets through the years surrounding the biggest stock mar-
ket crash in recent history, remain intact.
Ultimately, no matter what stage you presently find yourself in as a
trader or long-term investor, I hope you will be able to add this book to
your personal trader toolbox, to aid you in your future efforts in both bull
and bear markets.

FRANCIS JAMES CHAN

 The Prop
Traders
Chronicles
 CHAPTER 1

Eat a
Percentage of
What You Kill

ith a solid thundering crunch, Jacks foot landed against the wall

W of a Swift Trade Securities branchs trading floor, as he system-

atically progressed through his extensive arsenal of every known
curse word in the English language in stark contrast to the soft-spoken
business speak on the CNBC and ROB TV commentary originating from
the mounted television sets.
Even on a trading floor, where profanity is as common in everyday
life as public arguments are on the New York City subway system, Jacks
command of his R-rated vocabulary showed a mastery in its own right.
One might even imagine that it could be formalized into a new regional
dialect for use by a very primal tribe of hunters and gatherers who live to
accumulate a stockpile of resources eclipsing those of the average tribe in
its environment.
Despite all the forms of information bending from semi-denial to bla-
tant spin in its various forms throughout Wall Street and Bay Street, this
is a business with a culture that, by its very nature, revolves around the
accumulation and excesses of money. Even if the ends that justify that
means for each individual may vary from personal ego stroking to fantasies
of a philanthropic empire, the nature of the beast is fairly consistent and
predictable across the board. Beyond all the talk of controlled psychology
and discipline for professional traders, this is a business that ultimately
revolves around profit and loss.

1
2 THE PROP TRADERS CHRONICLES

And when Jack lost, he made it loud and clear to the other traders on
the floor. The only reason this had been tolerated for years was that he
profited from the markets more often than he got up off his seat to assault
the structure of the building. In fact, his profitable days were equal to many
college graduates yearly salaries. And while he was arguably an extreme
within a wide spectrum of personalities in the business, he was the epitome
of the types of personalities that I hadnt expected to see from profitable
traders after reading more books from the retail trading world than I was
probably expected to read at the start of my career in the world of propri-
etary trading.
I sat anxiously in the waiting area outside the interview room. Luckily, I
could see the trading floor through a window, which kept me occupied with
all kinds of visual stimulation. Aside from the CNBC and ROB TV commen-
tary on mounted screens, there were more tubes mounted over the trading
desks showing lines of green and red scrolling over a black background.
For a moment, I had considered that maybe this was some sort of indicator
custom developed by the company to signal buys and sells with the green
and red. In either case, whether these were colored lines of text or just
a Christmas-themed mood changer for traders, all I knew at the time was
that I had never seen anything like it before.
When I initially discovered my unexpected fascination with the finan-
cial markets, it was a lot like a new toy that I wanted to know everything
about. Strangely enough, what was more important for me was that it was
an area of interest that wasnt remotely expected of me at the time by
friends and family.
For unexplained reasons, I had always felt a personal satisfaction in
doing and choosing what others hadnt expected of meand to generally
be what others wouldnt have expected me to be. All the while, I was
becoming increasingly aware of the inherent self-defeating loop of contra-
diction that arises from attempting to go against the grain, especially when
living in or near a predominantly liberal-cultured city like Toronto or New
York City.
Having grown up in a small town surrounded by cottages, lakes,
and farms (aka overrated giant puddles and cow droppings, to sani-
tize my term for it at the time), located about an hours drive north of
Toronto, all the typical connotations associated with life in a crowded
and polluted city created a different context in my mind. During elemen-
tary school, I had hoped to eventually live and work in a major city like
Toronto or, better yet, New York itself. New York was (and still is) the