In most proprietary trading firms, the traders only trade two types of markets – the Stock market and the Futures market.
Some prop firms have a Forex desk as well but for the most part, the Stock market and the Futures market are the two main choices.
And they trade these two markets for a good reason…
Because they are profitable at it.
I was privileged enough to have been a proprietary trader for 4+ years, and if you’re curious about how prop traders actually trade…
Then you’re in luck because, in this post, I’ll reveal to you what goes on behind these prop firms.
And I’ll also share with you 3 Futures trading strategies that prop traders use to trade for a living.
If you’ve never been in a professional trading firm before, then this will give you a behind-the-scenes look into how prop traders really trade the markets.
Strategy #1: Order Flow Trading
The first strategy that prop traders use to trade the Futures market is called Order Flow Trading.
To trade Order Flow, traders use what is called the Depth-of-Market (DOM):
This is also referred to as the ladder by many traders.
This DOM is where you can see all the orders in the market and you can also place your trades as well.
So what exactly is Order Flow?
Order Flow, as the name suggests, is essentially the transactions of the orders that are taking place in the market.
There are 4 main pieces of information to read Order Flow:
- Bid & Offer Size.
- Market Profile (Total volume traded on each level).
- Transactions on the Inside Bid & Offer (Buy & Sell prints at each level).
- Bids & Offers Shaved (The orders that are pulled from the market).
Based on a combination of this information, the trader will decide as to where and when to buy and sell.
How to Trade Order Flow?
One way traders trade Order Flow is by using it to fade price levels.
There are 3 types of levels to fade:
- An extended price move.
- Psychological price levels.
- Intraday swing highs and swing lows.
Before fading the market, the trader will confirm with the DOM to see if it shows the right Order Flow.
If it does, then the trader will enter into a trade.
Here is a simple 5-step process to fade price levels:
Step 1: Pull out the 1-hour chart and draw a line on potential levels to fade (i.e. support, resistance, daily high, low, etc.).
Step 2: Go down to the 5-minute charts and plot a 20 EMA.
This will give an indication of momentum and it is normally where the market will consolidate.
Be wary of fading near the 20 EMA, and fade levels as far away from the 20 EMA as much as possible.
Step 3: Draw levels at the intraday highs and lows, and swing highs and swing lows.
Step 4: Look out for good levels to fade.
A good level to fade is one that is far away from the 20 EMA at the point of entry.
Wait till price has reached one of our targeted price levels, then turn to the DOM to look for an entry.
On the DOM, look for signs of absorption or slowing of selling before entering.
When To NOT Fade The Market
Knowing when not to fade is probably even more important than when to fade the market.
If you fade the market at the wrong time, it can even possibly wipe out your entire trading account.
Here are two key times when to not fade the market:
1) When a piece of major news is about to be released.
News moves will usually disregard price levels.
So there is no point to fade a move before any news is about to be released.
When trading Treasury Futures, be aware of big news announcements like Non-farm Payrolls, Interest Rate Decisions, and Bond Auctions.
During these times, the market can become very volatile…
So it would be best to stay away from the market until the market starts to settle again.
2) When there is a consolidation of price near your levels
Only fade levels where there is no consolidation near your targeted price levels.
Let’s say you have identified 20 to be a level you want to go Long.
If the market starts to consolidate around 21 – 23, then you will want to be on the safe side and not fade 20.
Now, this is just one of the ways traders use Order Flow.
There is another way that prop traders trade the Futures Market using Order Flow…
And that leads us to the next strategy…
Strategy #2: Scalping
The second strategy that prop traders use to trade the Futures market is called Scalping.
Scalping is simply taking profit at the smallest increment of price movement.
That means to take a 1-tick profit.
When scalping, traders also read Order Flow.
The only difference is that traders that purely scalp the market for 1 – 2 ticks at a time, do not use charts.
All they need is the DOM.
Because the DOM represents the rawest form of price action.
Through the DOM, you can see the buying, the selling, and the manipulation.
So to give you an idea of how prop traders scalp the market, I’ll use the analogy of buying cars.
For example, one day you are looking to buy a used car of a certain brand.
Now, instead of going to the used car dealer crooks, you decide to go to a special place where there are direct car owners who want to sell their cars.
Upon entering the place, you noticed that the place is split into two sections with a huge curtain in the middle.
On the left is a sign that says “Buyers” and on the right is a sign that says “Sellers”.
Since you want to buy a car, you go to the section for “Buyers”.
In this section, there are a total of 100 people including you.
And then you were given a piece of paper and written on that piece of paper is:
“I would like to buy the car for:
Please write your answer on the blank back page of this sheet of paper.”
You are then given a couple of minutes to complete this…
So you quickly wrote a big “$10,000” on the blank page because you want to get the car for as little as you can.
You were then asked to hold up that piece of paper with both hands.
After this, you were told to line up with the rest of the people holding their paper as well.
And you are to line up in descending order in front of the curtain starting from $15,000.
Since you were quick to write your answer down, you were the first in the queue of people who also wrote down “$10,000”.
Soon, all the others started to get in line according to their bidding price.
If you were to place it on the ladder, it would look something like this:
After forming up the line, you realized that there are 29 people behind you also wanting to buy at $10,000.
You start to wonder what if there is only one seller who wants to sell his car for $10,000…
Who then would be able to get it first?
And so you asked the event organizer this question, and to your delight he said:
“That would be you because you are first in line at that price.”
Suddenly, a realization hit you that it is an advantage to be the first in the queue!
Now that all the 100 buyers had been lined up, the event organizer announced:
“Let the buying and selling begin!”
He then pulled up the curtain to reveal the Sellers section where sellers are also lined up similarly to all the buyers.
However, you realized that the sellers had been lined up in ascending order from $16,000 to $20,000.
And more importantly, you realized that there are a total of only 50 sellers on the other side of the curtain.
And if you were to plot this on the DOM, it would look like this:
Upon seeing only 50 sellers, you realized that means that only 50 people would be able to buy a car.
The remaining 50 people would go home empty-handed.
And since you were bidding at $10,000…
Even though you were the first in line to buy at that price…
Chances are that you would probably go home empty-handed because there are already more than 50 buyers in front of you.
But, instead of just going home…
You stayed there and hoped a miracle would happen and some sellers would miraculously sell it to you at $10,000.
At this point, 5 minutes had passed but there was still no buying or selling at all.
You wondered what was going on, so you asked the event organizer why there hasn’t been any buying and selling.
The event organizer replied:
“Right now as you can see, the best bidder is only willing to buy at $15,000 and the best offer is willing to only sell at $16,000.
A transaction can only take place when both the buyer and seller can agree at the same price.
That is to say, that transaction can only take place if a buyer is willing to buy at a higher price from the seller at $16, or if a seller is willing to sell at a lower price at $15.”
At this point, other buyers heard this too.
Suddenly, the person who was queuing behind you stepped out of the queue…
And he quickly went over to the seller at $16,000 and paid him $16,000 to buy the car from him.
But, instead of going home after buying the car, he went to queue at the back of the $17,000 line.
Everyone else, upon seeing this, realized what was happening.
That person who bought the car at $16,000 realized that there were more buyers than sellers…
And he decided to take advantage of the situation to make a quick $1,000 by buying at $16,000 and then immediately selling at $17,000.
Now the DOM looks like this:
When other people saw this and realized what was happening, they too suddenly wanted to make a quick $1,000.
At this point, 5 buyers from the $11,000 queue rushed over to the $16,000 seller and wanted to make a transaction.
But there’s a problem – there were only 2 sellers and it was first-come-first-serve.
So, the first two buyers to reach the $16,000 queue could buy it that price.
The remaining 3 buyers missed out on it and could only now form a queue to buy at $16,000.
The 2 buyers who were fast enough to buy at $16,000 immediately went to the back of the queue at $17,000 hoping to profit a quick $1,000.
Something important was taking place.
The best Bid and Offer was no longer $15,000/$16,000.
It now became $16,000/$17,000.
This means that a buyer could no longer buy a car at $16,000 immediately because no seller was offering at that price anymore.
If a buyer wants to buy a car now, they would have to buy it at the best Offer of $17,000.
Now the DOM looks like this:
Now all the buyers who queued from $15,000 and below suddenly realized that the price of the car could get even higher.
They started to panic and rushed over to buy at the best Offer of $17,000.
And this caused the price to be pushed even higher.
This scenario that I have depicted is at the core the simplest form of how scalping takes place.
And is very much a game of psychology of what we perceive is going to happen in the market.
The guy who made the first move to buy at $16,000 perceived that others would also follow once they saw what was happening.
Because of that, he made a quick $1,000 profit.
This is scalping and is what I used to do all day long when I was at the equities desk at the prop firm.
Let’s now apply this to the Futures market.
Scalping Support & Resistance Levels
One of the simplest strategies to scalp the market is to scalp support and resistance levels.
By looking at the DOM, traders can identify places where there could be strong support and resistance just by volume alone.
Take a look at this DOM below:
By looking at the market profile, are you able to identify where there might be a possible support area?
If you said at 085 there could be a possible strong support level, then you are right.
If you were to see the market profile at 085, you will notice that there are 96,485 lots traded at the level.
That is to say that this level is a level of interest where other traders are placing more orders at this level than at any other level.
If you were to compare the current Inside Bid at 095 with a volume of 68,939, to 085 with a volume of 96,485, which do you think will provide a better Support area?
Most likely it would be 085.
And this is important to know because one of the traps that many traders fall into is to immediately trade support and resistance levels purely based on the chart.
Rather than immediately buy at support or sell at resistance…
Let the market trade around these levels first, then look for buyers or sellers coming in to support those levels.
For example, let’s say we are looking at the support level of 085…
We want to wait for the market to trade there first to confirm that the level will hold.
Let’s assume that the market has now traded down and is now 085.
This is what we see on the DOM:
You notice there is a high volume traded at 085.
Even when 085 turns Offer, it keeps coming back as Bid.
You notice that at 085, the volume has increased from 2000 to 4500.
That means 2500 lots have been traded there even when there were only 500 lots on the Bid when it first traded to 085.
From here you can see that there had been buyers coming in to buy the level at 085.
And if you notice 080, only 50 lots were sold into that level and it quickly became 085 Bid again.
So, how is it that at first there were only 500 lots on 085 but 2500 lots were transacted at that level?
It is most likely that there is an iceberg order at that level where the buyer is hiding his true buying size by breaking it into small chunks…
Or that other traders are also noticing this level and have decided to join in on the Bid to go Long at that price.
When you see this kind of action taking place on the DOM, then you know that the level is pretty strong.
So, to enter this trade, you can either join in on the Bid at 085 while the Bid is still smaller than the Offer…
Or you can lift the Offer once the Offer becomes smaller than the Bid and is about to go.
Once you’re in the trade, place an order on the Inside Offer for a 1-tick profit.
That’s how many prop traders scalp the market.
And if you are sharp and can read what the market is doing, then you can make a good living scalping the market.
Strategy #3: Spread Trading
The third strategy that prop traders use to trade the Futures market is called Spread Trading.
Spread Trading is generally used as a Mean Reversion trading strategy.
The strategy involves the simultaneous buying and selling of two correlated Futures markets.
So for example, if you’re trading index futures, then you might buy the Dow Jones futures and sell the S&P 500 futures.
And if you’re trading the treasury futures, then you might buy the Australia 10-Year Bond and sell the US 10-year Bond.
So how do you know when to enter into a trade?
It depends on the spread.
You see, when you plot two futures markets together, it will give you the spread as a chart.
To chart the spread, you would have to use a certain calculation to calculate the hedge ratios and derive a standardized format.
This calculation would also be adjusted from time to time by the prop firm and traders would update it according to the new values.
So how traders trade this spread is if the spread has deviated above the mean by a certain amount, they would Short the spread.
And if the spread has deviated below the mean by a certain amount, they would Long the spread.
Executing the Spread
To execute the spread can be tricky because you would have to enter into two different contracts at the same time.
While there is something called the Autospreader where it automatically gets into a spread for you…
When I was at the prop firm, we don’t use it because you can get a better entry when you manually get into the trades.
We call this Legging.
And that is to manually enter each “leg”.
For more complex spreads, there could be 4 legs or more that you have to enter simultaneously.
So if you leg wrongly, then it could result in a bad entry price.
When I was at the futures desk of the prop firm, the way we would leg into our positions would be to first enter our trade into the slower-moving market just as it is about to go off…
Then we would place a Limit Order on the faster moving market to try and get a better fill.
So let’s say I want to Long the slower-moving market and Short the faster-moving market.
What I’ll do first is wait until the Inside Offer on the slower-moving market is about to flip to become Bid…
Then I’ll quickly lift the Offer and place a Limit Order on the Offer of the faster-moving market.
This way, I can catch the momentum of the market going up, and get a good fill on the spread.
While this can sound tricky, when you get the hang of it, it will become much easier.
If you noticed, prop traders mainly use trading strategies that require you to trade frequently.
In fact, prop traders are encouraged to make many trades a day.
And the reason they can do that is that with the cumulative volume of the prop firm, they are able to get really low commission rates.
This is something that retail traders cannot get.
Furthermore, prop traders trade for a living.
They can sit in front of their screen all day long and get in and out of trades in a matter of minutes and some times even seconds.
So unless you are a prop trader or you have time to be in front of the screen hours at a time, these trading strategies might not be for you.
If you are a retail trader, then it might be better for you to trade the Forex market because the capital to get started is lower.
With Futures trading, your minimum risk per trade would be higher because of the size of the futures contract.
For example, if you were swing trading the Forex market, your risk per trade would be substantially lower than if you were to swing trade the Futures market.
The only way to reduce your risk per trade in the Futures market would be to do intraday trading like the prop traders.
That’s because, with intraday trading, your Stop Loss placement would be tighter compared to if you were doing swing trading.
Hence, if you’re new to trading, then trading the Forex market might be a better option for you.
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