Proprietary Trading: What It Is, How It Works, Benefits (2024)

What Is Proprietary Trading?

Proprietary trading refers to a financial firm or commercial bank that invests for direct market gain rather than earning commission dollars by trading on behalf of clients. Also known as "prop trading," this type of trading activity occurs when a financial firm chooses to profit from market activities rather than thin-margin commissions obtained through client trading activity. Proprietary trading may involve the trading of stocks, bonds, commodities, currencies, or other instruments.

Financial firms or commercial banks that engage in proprietary trading believe they have a competitive advantage that will enable them to earn an annual return that exceeds index investing, bond yield appreciation, or other investment styles.

Proprietary Trading: What It Is, How It Works, Benefits (1)

Key Takeaways

  • Proprietary trading refers to a financial institution using its own capital, rather than client funds, to conduct financial transactions.
  • Proprietary traders may execute an assortment of market strategies that include index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage, technical analysis, and/or global macro trading.
  • Market analysts understand that large financial institutions purposely obfuscate details on proprietary vs. non-proprietary trading operations in order to obscure activities promoting corporate self-interest.

How Does Proprietary Trading Work?

Proprietary trading, which is also known as "prop trading," occurs when a trading desk at a financial institution, brokerage firm, investment bank, hedge fund, or other liquidity source uses the firm's capital and balance sheet to conduct self-promoting financial transactions. These trades are usually speculative in nature, executed through a variety of derivatives or other complex investment vehicles.

Benefits of Proprietary Trading

Proprietary trading provides many benefits to a financial institution or commercial bank, most notably higher quarterly and annual profits. When a brokerage firm or investment bank trades on behalf of clients, it earns revenues in the form of commissions and fees. This income can represent a very small percentage of the total amount invested or the gains generated, but the proprietary trading process allows an institution to realize 100% of the gains earned from an investment.

The second benefit is that the institution is able to stockpile an inventory of securities. This helps in two ways. First, any speculative inventory allows the institution to offer an unexpected advantage to clients. Second, it helps these institutions prepare for down or illiquid markets when it becomes harder to purchase or sell securities on the open market.

See Also
Volcker Rule

The final benefit is associated with the second benefit. Proprietary trading allows a financial institution to become an influential market maker by providing liquidity on a specific security or group of securities.

An Example of a Proprietary Trading Desk

In order for proprietary trading to be effective and also keep the institution's clients in mind, the proprietary trading desk is normally "roped off" from other trading desks. This desk is responsible for a portion of the financial institution's revenues, unrelated to client work while acting autonomously.

However, proprietary trading desks can also function as market makers, as outlined above. This situation arises when a client wants to trade a large amount of a single security or trade a highly illiquid security. Since there aren't many buyers or sellers for this type of trade, a proprietary trading desk will act as the buyer or seller, initiating the other side of the client trade.

How Does Proprietary Trading Work?

Proprietary trading occurs when a financial institution trades financial instruments using its own money rather than client funds. This allows the firm to maintain the full amount of any gains earned on the investment, potentially providing a significant boost to the firm's profits. Proprietary trading desks are generally "roped off" from client-focused trading desks, helping them to remain autonomous and ensuring that the financial institution is acting in the interest of its clients.

Why Do Firms Engage in Proprietary Trading?

Financial institutions engage in proprietary trading as a way of benefitting from perceived competitive advantages and maximizing their profits. Since proprietary trading uses the firm's own money rather than funds belonging to its clients, prop traders can take on greater levels of risk without having to answer to clients.

Can Banks Engage in Proprietary Trading?

The Volcker Rule, implemented in response to the 2007-2008 financial crisis, places restrictions against large banks using their own accounts for short-term proprietary trading of securities, derivatives, and commodity futures, along with options on these instruments. The rule is designed to shield customers bypreventing banks from making the types of speculative investments that contributed to the Great Recession.

The Bottom Line

Proprietary trading occurs when a financial institution carries out transactions using its own capital rather than trading on behalf of its clients. The practice allows financial firms to maximize their profits, as they are able to keep 100% of the investment earnings generated by proprietary trades. Institutions such as brokerage firms, investment banks, and hedge funds frequently have proprietary trading desks. However, there are restrictions against large banks engaging in prop trading, designed to limit the speculative investments that contributed the 2007-2008 financial crisis.

Proprietary Trading: What It Is, How It Works, Benefits (2024)

FAQs

Proprietary Trading: What It Is, How It Works, Benefits? ›

Proprietary trading occurs when a financial institution trades financial instruments using its own money rather than client funds. This allows the firm to maintain the full amount of any gains earned on the investment, potentially providing a significant boost to the firm's profits.

What are the benefits of prop trading firms? ›

Firstly, prop trading firms provide access to substantial capital that traders can utilize to amplify their trading positions and potential profits. This access to leverage allows traders to take advantage of market opportunities that they might not have been able to access with their own funds.

What is the purpose of proprietary trading? ›

Propriety trading allows firms to wave the fees, not apply the spread to the trade as well as the benefit from all the in-house knowledge, skills and expertise to profiteer from and add to the bottom line.

What is proprietary trading advantages and disadvantages? ›

However, if you understand the risk and trust the management and its operations, proprietary trading offers many advantages, although it mostly involves day trading. At the end of the day, the main advantage of proprietary trading is leverage, and the main disadvantage of proprietary trading is fraud.

Why work in proprietary trading? ›

Proprietary traders have access to sophisticated software and pools of information to help them make critical decisions. Although commonly viewed as risky, proprietary trading is often one of the most profitable operations of a commercial or investment bank.

Do prop traders make good money? ›

And that single difference creates many other differences: Prop trading Partners can take a much higher percentage of the profits for themselves. The much smaller capital base (tens of millions up to hundreds of millions), means that it's possible to earn extremely high annual returns (100%, 200%+, etc.).

Do prop firms give you real money? ›

Sure, the firm may replicate successful trades of the funded traders on the firm's real account. But, again, those are trades made by the firm itself with its own capital. And in general, prop firms insist that they are not financial institutions and do not provide financial services.

How do proprietary traders make money? ›

How Does Proprietary Trading Work? Proprietary trading occurs when a financial institution trades financial instruments using its own money rather than client funds. This allows the firm to maintain the full amount of any gains earned on the investment, potentially providing a significant boost to the firm's profits.

Why is proprietary trading risky? ›

3.1 Classic proprietary trading

This almost always involves taking market risk, which is the risk that changes in the market prices of financial instruments or commodities may create a loss for the firm.

How do prop firms make money? ›

Prop firms fund traders to earn a share of their profits, which constitutes a major part of their revenue, and may also gain income through subscription, joining fees, and selling educational courses.

What happens if you lose money in prop trading? ›

Proprietary trading firms often provide evaluation accounts where you prove your trading skills. Usually, you pay a one-time fee to enter this "challenge." If you lose money during this evaluation, you won't owe anything beyond the initial fee.

Is proprietary trading a good career? ›

Prop traders often get a base salary, a cut of the profits and performance bonuses. Six- or seven-figure incomes aren't rare in prop trading. Don't Miss: Webull and Robinhood may have revolutionized stock market investing, but this prop trading firm is reshaping the game for profitable traders.

Is proprietary trading illegal? ›

Prohibition on Proprietary Trading

The prohibition against proprietary trading applies not only to banks themselves but also to bank holding companies. Proprietary trading here is very broad, including almost all securities, derivatives, and futures.

How much money do you need to open a prop firm? ›

The amount of money needed to start a prop trading firm can vary depending on various factors such as the type of assets traded, the size of the firm, and the location. However, in general, you would need at least $50,000 to $100,000 to start a prop trading firm in India.

How to become a proprietary trader? ›

To become a proprietary trader, earn a bachelor's degree in finance, business, or mathematics. Complete at least one internship with a trading firm to learn about the finance industry and make professional connections. Apply for an entry-level proprietary trader role.

Which prop firm is the best? ›

The most popular prop trading firms and funded programmes
  • Axi Select.
  • FTMO.
  • The Forex Funder.
  • E8 Markets.
  • True Forex Funds.
  • The 5%ers.
  • Funded Next.

Is prop firm a good idea? ›

Prop firms are an excellent source of accessing further capital to increase profit potential. Passing a prop firm's evaluation means reaching a profit target while staying within its risk management rules. Prop firms require traders to use their brokers, which can be positive or negative depending on the broker.

What are the negatives of prop firms? ›

Foreign Exchange Specialist at FTMO.
  • Strict Risk Management Rules and Trading Guidelines: ...
  • Profit Sharing: ...
  • Profit Targets During the Evaluation Period: ...
  • Limited Control Over Capital and Payouts: ...
  • Lack of Regulatory Oversight: ...
  • High Leverage and Margin Requirements: ...
  • Financial Risk and Capital Exposure:
Feb 11, 2024

Why do prop traders make so much money? ›

Commissions: Prop trading firms often charge commissions on trades made by their traders. These commissions can range from a few dollars to hundreds or even thousands of dollars per trade, depending on the size and complexity of the transaction. This is one of the primary sources of income for prop trading firms.

How do prop firms get their money? ›

Commission: Prop firms may charge a commission on each trade made by their traders. Profit Split: In some cases, prop firms may take a percentage of the profits earned by their traders as a form of compensation. Training Fees: Some prop firms offer training programs for new traders, which may come at a cost.

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