Proprietary Trading (2024)

Trading using a bank's own money, instead of that of its clients

Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.

Proprietary Trading (Prop Trading) occurs when a bank or firm tradesstocks, derivatives, bonds, commodities, or other financial instruments in its own account, using its own money instead of using clients’ money. This enables the firm to earn full profits from a trade rather than just the commission it receives from processing trades for clients.

Banks and other financial institutions engage in this type of trade with the aim of making excess profits. Such firms often have an edge over the average investor in terms of the market information they have. Another advantage comes from having sophisticated modeling and trading software.

Prop traders use various strategies such as merger arbitrage, index arbitrage, global macro-trading, and volatility arbitrage to maximize returns. Proprietary traders have access to sophisticated software and pools of information to help them make critical decisions.

Proprietary Trading (1)

Although commonly viewed as risky, proprietary trading is often one of the most profitable operations of a commercial or investment bank. During the financial crisis of 2008, prop traders and hedge funds were among the firms that were scrutinized for causing the crisis.

The Volcker Rule, which severely limited proprietary trading, was introduced to regulate how proprietary traders can operate. A major concern was avoiding possible conflicts of interest between the firm and its clients. Individual investors do not benefit from prop trading because the activity does not involve trades executed on behalf of clients.

Benefits of Proprietary Trading

One of the benefits of proprietary trading is increased profits. Unlike when acting as a broker and earning commissions, the firm enjoys 100% of the profits from prop trading. As a proprietary trader, the bank enjoys maximum benefits from the trade.

Another benefit of proprietary trading is that a firm can stock an inventory of securities for future use. If the firm buys some securities for speculative purposes, it can later sell them to its clients who want to buy those securities. The securities can also be loaned out to clients who wish to sell short.

Firms can quickly become key market markers through prop trading. For a firm that deals with specific types of securities, it can provide liquidity for investors in those securities. A firm can buy the securities with its own resources and then sell to interested investors at a future date.

However, if a firm buys securities in bulk and they become worthless, it will be forced to absorb the losses internally. The firm only benefits if the price of their security inventory rises or others buy it at a higher price.

Proprietary traders can access sophisticated proprietary trading technology and other automated software. Sophisticated electronic trading platforms give them access to a wide range of markets and the ability to automate processes and engage in high-frequency trading. Traders can develop a trading idea, test its viability, and run demos on their computers.

In most proprietary companies, the trading platforms used are exclusively in-house and can only be used by the firm’s traders. The firms reap substantial benefits from owning the trading software, something that retail traders lack.

Hedge Fund vs. Prop Trading

Hedge funds invest in the financial markets using their clients’ money. They are paid to generate gains on these investments. Proprietary traders use their firm’s own money to invest in the financial markets, and they retain 100% of the returns generated.

Unlike proprietary traders, hedge funds are answerable to their clients. Nonetheless, they are also targets of the Volcker Rule that aims to limit the amount of risk that financial institutions can take.

Proprietary trading aims at strengthening the firm’s balance sheet by investing in the financial markets. Traders can take more risks since they are not dealing with client funds.

Firms go into proprietary trading with the belief that they have a competitive advantage and access to valuable information that can help them reap big profits. The traders are only answerable to their firms. The firm’s clients do not benefit from the returns earned through prop trading.

The Volcker Rule on Proprietary Trading

The Volcker rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It was suggested by the former chairman of the Federal Reserve, Paul Volcker.

The rule aims to restrict banks from making certain speculative investments that do not directly benefit their depositors. The law was proposed after the global financial crisis when government regulators determined that large banks took too many speculative risks.

Volker argued that commercial banks engaged in high-speculation investments affected the stability of the overall financial system. Commercial banks that practiced proprietary trading increased the use of derivatives as a way of mitigating risk. However, this often led to increased risk in other areas.

The Volcker Rule prohibits banks and institutions that own a bank from engaging in proprietary trading or even investing in or owning a hedge fund or private equity fund. From a market-making point of view, banks focus on keeping customers happy, and compensation is based on commissions. However, from a proprietary trading point of view, the customer is irrelevant, and the banks enjoy the full profits.

Separating both functions will help banks to remain objective in undertaking activities that benefit the customer and that limit conflicts of interest. In response to the Volcker rule, major banks have separated the proprietary trading function from its core activities or have shut them down completely. Proprietary trading is now offered as a standalone service by specialized prop trading firms.

The Volcker Rule, like the Dodd-Frank Act, is generally viewed unfavorably by the financial industry. It is seen as unnecessary and counterproductive government interference. For example, as noted above, banks’ proprietary trading provided important liquidity for investors. That source of liquidity is now gone.

Related Resources

Thank you for reading CFI’s guide on Proprietary Trading. To keep advancing your career, the additional resources below will be useful:

Proprietary Trading (2024)


Proprietary Trading? ›

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.

Is proprietary trading legal? ›

The Volcker Rule prohibits banks and institutions that own a bank from engaging in proprietary trading or even investing in or owning a hedge fund or private equity fund. From a market-making point of view, banks focus on keeping customers happy, and compensation is based on commissions.

Why is proprietary trading risky? ›

By definition, classic proprietary trading involves taking positions in financial instruments or commodities. 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.

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 legit? ›

Prop businesses nowadays are utterly unregulated and far apart from the banking industry. As a result, these internet prop companies are legitimate and not a fraud.

Do prop traders make 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 proprietary traders get paid? ›

Prop traders make all or most of their income from splitting profits they generate in financial markets with the prop firm that provides them with capital. Prop traders face the same challenges as other traders but benefit from access to capital, technology, and interaction with other skilled traders.

Who are the famous proprietary traders? ›

Famous traders

Famous proprietary traders have included Ivan Boesky, Steven A. Cohen, John Meriwether, Daniel Och, and Boaz Weinstein.

Is it hard to become a prop trader? ›

Getting accepted into a proprietary trading firm as a funded trader can be challenging, but it largely depends on your trading skills, experience, and the specific requirements of the firm.

How much do Prop traders make a year? ›

Proprietary trader salaries typically range between $60,000 and $165,000 yearly. The average hourly rate for proprietary traders is $48.09 per hour. Proprietary trader salary is impacted by location, education, and experience.

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.

How much money to start a prop trading firm? ›

To summarize, the amount of money you need to open a prop firm can range from $10,000 to $1 million, depending on the type of prop firm, the technology, the registration, the liquidity, and the CRM tool.

What percentage of prop traders make money? ›

The article from Lux Trading Firm provides slightly different results. According to it, 4% of traders, on average, pass prop firm challenges. But only 1% of traders kept their funded accounts for a reasonable amount of time.

Does proprietary trading still exist? ›

Prop trading exists at hedge funds, asset management firms, commodities companies like Vitol and Glencore, and small/independent trading firms – and it used to exist at large banks before the 2008 financial crisis. In practice, “prop trading” usually refers to the smaller, independent firms that focus on market-making.

Is self trade illegal? ›

Intentional wash trades are illegal self-matches that can manipulate markets by giving the impression of legitimate trading interest or activity at a certain price, time, and size. FIA PTG supports efforts to prohibit this activity. There are also two forms of self-matches that can occur unintentionally.

What makes trading illegal? ›

A person who becomes aware of non-public information and trades on that basis may be guilty of a crime. Trading by specific insiders, such as employees, is commonly permitted as long as it does not rely on material information not available to the general public.

What happens if you lose money in prop trading? ›

Profits from trades are generally divided between the firm and the prop trader; however, the risk distribution is asymmetric. This means that in the event of a loss, the trader bears 100% of the losses, while they don't receive 100% of the profits.

Top Articles
Latest Posts
Article information

Author: Rueben Jacobs

Last Updated:

Views: 5939

Rating: 4.7 / 5 (77 voted)

Reviews: 84% of readers found this page helpful

Author information

Name: Rueben Jacobs

Birthday: 1999-03-14

Address: 951 Caterina Walk, Schambergerside, CA 67667-0896

Phone: +6881806848632

Job: Internal Education Planner

Hobby: Candle making, Cabaret, Poi, Gambling, Rock climbing, Wood carving, Computer programming

Introduction: My name is Rueben Jacobs, I am a cooperative, beautiful, kind, comfortable, glamorous, open, magnificent person who loves writing and wants to share my knowledge and understanding with you.