Proprietary Trading Explained
Proprietary trading (also known informally as Prop trading) refers to when a financial institution such as a commercial bank, a brokerage firm or even an investment bank directly trades or invests in activities in the stock market.
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To be a successful trader, you need to have a good grasp of some of the terms used in trading. One of these terms is proprietary trading. For your convenience, we have compiled all you need to know about prop trading in this article; the pros and cons and any other questions you may have. Let’s get right to it!
Try prop trading with SurgeTrader!What Is Prop Trading?
Proprietary trading involves a firm using its own capital, leverage, and resources to invest, trade, and speculate in financial markets such as stocks, bonds, currencies, commodities, and derivatives. The goal is to generate profits from the firm's own market positions and trading activities.
Prop traders place trades based on the firm's strategies, research, analytics, and risk appetite. Their compensation and bonuses are often tied directly to their trading performance and profits.
Distinction from other trading activities:
Proprietary trading is distinct from other trading done on behalf of clients. With prop trading, all profits and losses accrue directly to the firm's accounts.
It differs from market making, where firms facilitate trading by providing liquidity and taking the other side of client trades. Market makers aim to capture the bid-ask spread rather than take directional positions.
Key players in prop trading
Investment banks. Many have prop trading desks that trade the bank's capital in markets like equities, fixed income, Forex, commodities, and derivatives.
Hedge funds. Prop trading is core to their active trading strategies and use of leverage. They invest in diverse markets and asset classes.
Commodity trading firms. Firms focused on trading commodities and energy markets like oil and gas. They use their specialized knowledge to trade for the firm's book.
High-frequency trading firms. They use algorithms and high-speed technology to implement proprietary strategies and trade based on micro price movements.
How Does a Prop Trading Company Work?
A prop trading company as mentioned earlier is usually a big financial institution that engages directly in stock market activities. Prop trading occurs when a trading desk at a financial institution uses the firm’s resources and accounts to carry out self-promoting monetary trades. These trades are often speculative in nature and are performed through a range of derivatives or other complex investment vehicles.
However, it isn't the firm as an entire entity that engages in the trades, it does so through prop traders. A prop trader gets into an agreement with the organization as an independent trader and not an employee or client, to conduct day trades through the company's account. The trades are done with company funds.
However, to become a prop trader, you have to first deposit an amount usually referred to as risk contribution. Your risk contribution determines how much leverage you are given by the company. I’m sure you are wondering why it’s called risk contribution. This is because any losses incurred during a trade are offset by the trader’s deposit (risk contribution).
The risk contribution shows that you have the company’s best interests at heart and you will not get involved in extremely risky trades because you will lose your money as well. The company and not the prop trader is the party to each stock trade and so it is the one that sustains any losses in any trade. Learn also how prop trading firms make money.
Prop Trading Strategies
Directions trading. Taking long or short positions based on a view of market direction. May involve fundamental or technical analysis.
Statistical arbitrage. Using quantitative models and algorithms to capture pricing anomalies and inefficiencies.
High-frequency trading. Executing a high volume of trades to capitalize on small price movements. Leverages speed and data.
Merger arbitrage. Trading the stock of companies involved in announced M&A deals and capturing the spread.
Volatility trading. Strategies that benefit from volatility and price movements rather than just direction, like options trading.
Prop Trading Examples
You deposit a small amount, for instance, 5,000 USD which then gives you access to trade with significantly higher leverage than normal PDT rules. The more money you deposit, the larger the leverage that you can access. One thing that you must note is that you have to bear 100% of all losses incurred during a trade. When you conduct trade for example buying a profitable stock through the company’s accounts and then later selling it at a higher price, the commission is low and you get a split of the profits (around 85-90%).
6 Best Forex Funded Accounts ComparedHow to Become a Prop Trader?
How to become a day trader in a prop companyThe first step to becoming a prop trader is conducting research. Learn as much as you can about prop trading and equip yourself with the skills and knowledge of conducting a successful trade. You can do this through online learning platforms or physically going to proprietary firms where you will be trained.
Once you have amassed sufficient knowledge, skills, and tools to enable you successfully conduct prop trading, then you can approach a prop trading firm. It is advisable as earlier mentioned to conduct research and background checks on the firm before committing. Once you are satisfied that the organization is credible you will then need to deposit a risk contribution which will give you access to high leverage.
When you conduct in-house prop trading at the firm's premises then you will likely get access to advanced and sophisticated technology which is hard to get your hands on. You will also have access to high-level information which improves your chances of success when undertaking trades. Alternatively, you can also trade remotely through licensed software. However, remote trading doesn't offer as many benefits as in-house trading. Read the Traders Union article for the best way to find a job in prop trading.
How Much Money Can a Prop Trader Make?
Although largely viewed as risky, prop trading is one of the most profitable operations conducted by financial institutions. The amount made by a prop trader is usually dependent on a predetermined profit-sharing ratio. The amount earned depends wholly on the profit made by a prop trader depending on the commissions, negotiations, profitability, volume, etc. This means that the possibilities are infinite.
The amount of profit from trade is usually shared between the firm and the prop trader but then the risk is asymmetric. This means that in case of a loss you bear 100% of the losses while you don't get 100% of the profits. Most companies keep between 10-25% of all profits and give the prop trader the rest. You must understand that trading, especially day trading, is highly volatile, meaning that you can make millions and at the same time you can lose the same.
How Much Can I Earn Trading in Forex?How to Choose a Prop Trading Firm?
The biggest struggle for prop traders is usually finding a good prop trading firm. This is because as mentioned earlier there is a high risk of getting defrauded by a company posing as a prop trading firm. Ensure that the firm that you are partnering with is legitimate with a good track record. Check for testimonials and reviews on multiple platforms.
You can also conduct checks on the managers to confirm that they haven’t been involved in any scandals or unscrupulous dealings before. Make sure that you do proper due diligence and understand the risks that are involved with prop trading.
7 Best day trading (prop) firms in 2024Best Prop Trading Accounts 2024
Pros and Cons of Proprietary Trading
👍 Prop Trading Pros
Prop trading has a couple of advantages which we are going to highlight in this section.
•1. Increased Profits:
Prop trading allows institutions to earn a higher amount of profits than when acting as a broker and earning only commissions.
•2. Stockpile Inventory of Securities:
Prop trading allows a firm to stock up on shares/securities. These inventories can be sold to clients when the market becomes illiquid or when it becomes harder to purchase or sell securities on the open market.
•3. Proprietary Trading Firms Offer Rebates:
Rebates are defined as compensation given when you add liquidity to the market. All prop trading firms offer rebates, which you are unlikely to get as a retail client.
•4. Proprietary Trading Firms Offer Good Support:
Because of the nature of business, prop trading firms are usually closely-knit operations involving only a few people. This means that client support is quick and any issues can be solved using a simple phone call. Contrary to trading through a retail broker that has thousands if not millions of customers where sometimes contacting customer service can prove frustrating due to long waiting times.
•5. Proprietary Trading Involves Leverage:
What this means is that apart from having many open orders, you can also have several filled orders. Leverage limits are usually not strictly enforced in most proprietary firms, especially if you have a track record spanning several years.
•6. Proprietary Trading is Good for Providing Liquidity via Open Orders:
If you usually trade mostly in open positions, then prop trading is a better option compared to being a retail client. Some prop trading firms allow you to have more than a thousand open orders at the same time.
•7. Prop Trading Offers an Easy Entry to Trading for “Undercapitalized” Traders:
If you have less than 25,000 USD to invest then a proprietary account might be a viable go-to. This is because your buying power can exceed anything you get as a retail client.
•8. Proprietary Trading Firms Let You Diversify and Reduce Risk:
Even if you have a big bank account, prop trading can still be a viable option. You can have a small deposit then use margin (capital you can afford to lose), and invest the rest of your capital in stocks or mutual funds for capital appreciation.
•9. Prop Trading Firms Offer Multiple Trading Platforms:
One huge advantage with prop trading firms is they let you choose among several platforms. This is a huge advantage because as a retail trader, you are usually bound to whatever the retail firm offers you.
•10. Prop Trading Offers Big Inventory Lists for Short Sales:
To effectively sell short, you first need to locate shares, and prop trading firms allow you to do this. As a retail client, you might have limited opportunities to locate shares and sell short. Some stocks may be on the threshold or ‘hard to borrow’ list and may be unavailable for short selling.
👎 Prop Trading Cons
Like all things in life, prop trading also comes with a couple of disadvantages which we are going to highlight in this section.
•1. Proprietary Firms Are Less Regulated Than Retail Brokers:
Most prop trading firms that provide remote trading are not regulated at all. This is a double-edged sword because it is both a good and bad thing. Not being regulated means that there are fewer operating costs. The downside is that without regulation then you are at risk of losing your capital at any time especially if the principals are swindlers.
Therefore, you should conduct some research and deep background checks on the company and the managers. If you find any integrity or honesty issues, then ask yourself if it is a risk you are willing to take. Moreover, being unregulated means that a single rogue trader can put the whole firm in jeopardy.
•2. Risk of Losing Money:
As a prop trader, your deposit is not insured and is liable to fraud and other business risks. This is mostly because of the lack of or minimal regulation. Because of this, it’s advisable for you to only deposit an amount that you can afford to lose. Retail clients on the other hand have their money insured because of strict regulation of retail firms.
The good thing is that the deposit can be very small and a decent trader can make a 100% return on the equity per month.
•3. Proprietary Trading Fees are High:
Most prop trading firms charge fees for the software you’re using, especially if you trade remotely. The monthly fees normally start at about 200 USD for software alone. Compared to the fees that retail clients pay then you might find the prop trading fees outrageous.
•4. Prop Trading is Mostly Day Trading:
Even though proprietary trading offers high leverage, this usually applies only to day trading. If you decide to hold an overnight position, then you will most likely not get much leverage. What’s more, most prop firms only offer day trading.
•5. Proprietary Firms Can Steal Your Intellectual Property:
For exceptional traders with great trading strategies, there is a high possibility that someone at the back office is working hard to decode your strategy. There are cases where firms piggyback on clients’ strategies and teach them to computers through machine learning.
FAQs
Is Prop Trading Illegal?
No, prop trading is not illegal but you need to be careful, especially in strictly regulated countries such as the US.
What Is a Prop Trader?
A prop trader is an individual who uses a firm’s resources to invest in a variety of assets like stocks, bonds, commodities, etc. A prop trader commits a small amount to the firm to guarantee that they will conduct responsible trades with the firm’s interest in mind.
Can a Prop Trader Trade in Anything They Want?
Prop traders are usually given strict guidelines by the firm regarding how much they can trade and what types of trades they can make.
Is Prop Trading Profitable?
You must understand that prop trading involves several risks as much as it is profitable. If you can manage the risks associated with prop trading, you can certainly earn a fortune from the venture.
Team that worked on the article
Andrey Mastykin is an experienced author, editor, and content strategist who has been with Traders Union since 2020. As an editor, he is meticulous about fact-checking and ensuring the accuracy of all information published on the Traders Union platform. Andrey focuses on educating readers about the potential rewards and risks involved in trading financial markets.
He firmly believes that passive investing is a more suitable strategy for most individuals. Andrey's conservative approach and focus on risk management resonate with many readers, making him a trusted source of financial information.
Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.
The topics he covers include trading signals, cryptocurrencies, Forex brokers, stock brokers, expert advisors, binary options. He has also worked on the ratings of brokers and many other materials.
Dr. BJ Johnson’s motto: It always seems impossible until it’s done. You can do it.
Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO). Mirjan is a cryptocurrency and stock trader. This deep understanding of the finance sector allows her to create informative and engaging content that helps readers easily navigate the complexities of the crypto world.