Proprietary trading, prop trading for short, is a corporate financial trading strategy where businesses, companies, and financial institutions trade stocks, options, futures, and derivates using their own capital instead of funds from clients.
Prop trading presents these entities with an option to increase their profits significantly. However, the downside to prop trading is that entities use their own capital, which involves taking on significant risk.
This article will explore prop trading and answer everything you need to know about it.
What Is Prop Trading?
Proprietary trading involves trading financial instruments using a firm’s capital instead of trading on behalf of clients or customers. In other words, prop traders use the firm’s money to take positions in the market to earn profits for the firm, not from commissions by trading on behalf of customers.
Prop trading is a trading strategy that can be done in various financial markets, such as stocks, bonds, currencies, and commodities. Prop traders also use a variety of market strategies, including index arbitrage, merger arbitrage, technical analysis, and more.
Types of Prop Trading
Prop trading firms fall under three distinct types, each with its own approach and focus. The types of prop trading firms include the following:
Traditional Prop Trading Firms
Traditional proprietary trading firms are the most widespread and longest-standing type of prop trading. These firms utilize a combination of traders and firm capital to achieve their trading objectives. However, traditional prop trading firms are also the most restrictive type of prop trading, with firms adhering to regulations and certifications.
The second prop trading type is prop shops. Prop shops invest large amounts of risk capital in offering traders access to markets. With that said, prop shop traders aren’t required to have formal qualifications or certifications, but they must show a positive track record to engage in proprietary trading.
Remote Prop Trading Firms
Remote prop trading firms are online-based entities that offer individuals funded trading accounts to engage in prop trading. These firms operate remotely and do not require traders to have any qualifications, certifications, or even capital to trade. Many of these firms offer traders-funded accounts for prop trading activities.
How Does Prop Trading Work?
We’ve established what prop trading is, and we’ve explained the types of proprietary trading firms. Now, let’s look at how prop trading works.
Prop trading works by leveraging the firm’s capital to take positions in the market. Traders use their knowledge of market trends and analysis to identify profit opportunities.
Proprietary trading can be done manually or through algorithmic trading. Proprietary traders may also use various trading strategies, such as long-term investments or short-term speculation, to generate profits.
Pros and Cons of Prop Trading
Prop trading comes with several pros and cons. Let’s look at that:
Pros of Prop Trading
- Proprietary trading offers potential rewards such as high profits – 100% of profits compared to earning revenues in the form of commissions and fees when trading on behalf of clients.
- Prop trading generally involves greater autonomy of traders.
- Prop trading is more flexible.
Cons of Prop Trading
- Prop trading is risky and involves higher potential losses.
- Proprietary trading desks are a high-pressure environment.
- Prop trading presents the possibility of developing conflicts of interest.
- Prop trading is also subject to regulatory oversight and can be affected by market conditions.
Considering the pros and cons is essential for gaining a surface-level overview of proprietary trading. For example, while prop trading profits are exceptionally higher than earning trading commissions, the potential losses are also much higher due to using the firm’s own capital.
Why Do Firms Engage in Prop Trading?
So that begs the question, why do firms engage in prop trading?
Firms engage in prop trading for a variety of reasons, including:
- To generate profits and diversify their revenue streams.
- To hedge against risks in other parts of the business.
- To attract and retain top trading talent.
Despite the potential risks and other cons involved in prop trading, prop trading is a highly popular trading strategy among financial films and commercial banks.
Proprietary trading, or prop trading, is a type of trading where firms use their own capital to buy and sell financial instruments to earn profits for the firm. Prop trading is done in a variety of markets and involves leveraging the knowledge of market trends and extensive analysis.
While prop trading offers potential rewards, it also comes with risks and regulatory oversight. Firms engage in prop trading for a variety of reasons, including generating profits and diversifying revenue streams.
A prop trade is when a financial firm engages in trading activities using its own capital instead of making trades on behalf of clients and customers to generate commission-based revenue.
No, prop trading is not illegal. But large banks are prohibited from engaging in prop trading. Moreover, you cannot be a prop trader in one of these entities.
Prop traders work as contractors for prop trading firms and entities and get paid an hourly wage and salary on top of earning a small fee when generating a profit through successful prop trades.