Proprietary trading, otherwise known as prop trading, is when a trader does trading via capital issued to them by some proprietary firm or institution and not private. They trade in very different financial markets, with any instrument available at their disposal, from simple stocks to the more complex—options, futures, and even CFDs.
The core objectives of prop trading are to earn profits for that institution using allocated capital strictly meant for trading.
Who practices Prop Trading?
Some offices are only focused on proprietary trading. It should also be practiced among:
- Investment Banks: Many banks have a resigned desk dedicated to prop trading, leveraging access to valuable information and order flow visibility. However, the financial crisis of 2008 led to strict rules and regulations on prop trading within these institutions.
- Hedge Funds: These entities manage investments for their clients along with trading their capital. They also engage in sophisticated prop trading strategies.
- High-Frequency Trading Firms: These firms, usually act as market makers, and execute trades at a fast speed.
- Commodity Trading Firms: Large companies like Glencore, Vitol, and Trafigura have dominated the present and futures markets, by trading large quantities of commodities worldwide.
Who is a Prop Trader?
A prop trader is a dealer who engages in speculative trading to generate profits within the firm, independently of clients, using the firm’s own money. He may have both short- and long-term elements in his book.
Proprietary trading firms usually grant their traders a lot of independence in decision-making while trading. However, they impose one important safeguard called maximum drawdown level. In this way, if a trader’s losses reach the amount set by the firm, then the firm steps in and stops the trader’s operations to avoid further risk of financial loss.
Mostly, prop traders live on a profit-sharing basis where they share the profits made with the firms that have given them trading capital. They battle in absolutely the same battleground but with enormous capital, cutting-edge technology, and an interactive environment side by side with other highest-performing traders.
How does Prop Trading work?
Proprietary trading gets financial institutions involved in leveraging their substantial capital for engaging in trading activities that aim at producing profits. The process of prop trading starts with the allocation of a part of its funds by the prop trading desk. Traders are supported by modern research and technology teams.
The market data, news, and various indicators to make informed and strategic trading decisions are accurately analyzed by these traders. The execution of trades is done with the help of advanced trading platforms by taking benefit of high technology and speedy connectivity to quickly enter and exit positions.
The success of prop trading relies on the trader’s skills, current market conditions, and strong risk management practices.
Benefits of Prop Trading
Prop trading benefits prop traders and financial institutions in the following ways:
- Revenue Generation: The main goal of proprietary trading is to produce robust profits for the financial institution. By using the amount from their capital and leveraging complex trading strategies, these institutions continue to earn potential for achieving particular profits in return from their traders.
- Risk Management: Proprietary trading permits institutions to manage and control their trading activities along with their risks. Prop traders can now act on their case. They are now able to manage their trade positions and maintain risk-level without any interference from the institution, which is the opposite of traditional trading.
- Talent Attraction: Managing and working on a prop trading desk allows financial institutions to be attracted to highly skillful trading individuals.
- Market Liquidity Provision: In particular, Proprietary traders, who are involved in market making, play an important character by providing liquidity to financial markets. They ensure smoother and more efficient market operations.
- Research and Innovation: Prop trading desks do the work of researching new technology to make a profit in a competitive market. This resource investment benefits in the enhancement of the overall understanding and details of financial markets along with the trading desk of the institution.
- Diversification of Revenue Streams: Proprietary trading provides financial institutions with an additional revenue stream that does not rely on the traditional client-based contract. This diversification helps in strengthening the financial stability of the institution.
What is a Prop Trading Firm?
A proprietary trading (prop) firm is a unique company that gives substantial capital to its traders. While trader gets substantial capital, they also have to share part of their earned profit with the company according to the agreement signed.
Ambitious and desired expert traders go through many complications throughout their path to success. The challenging thing is the lack of adequate capital. Traders may also face challenges like inadequate access to innovative technology, detailed market data, and important tools.
Prop firms tend to play an important role in helping creative and skillful individuals accelerate their trading careers. The company offers substantial capital, training, and overall support.
Prop firm’s structure is likely to vary widely. Certain prop firms maintain their physical office by providing traders with their respective desks and workspaces. Some function entirely remotely. It allows them to accept and support traders worldwide.
How does Prop Trading Firm make money?
The main resource of revenue comes straight from the profits made by traders for proprietary trading firms. These types of firms have a profit-sharing contract with their traders. For example, if the profit generated by the trader is $100,000 over a specific period with having an 80-20 profit-sharing agreement, the trader, according to the contract will get $80,000, while the remaining $20,000 would go to the firm.
In addition to profit-sharing, some smaller prop firms generate revenue by offering educational services, providing access to their capital allocation programs, or leveraging their office space and technology. However, these sources typically represent a minor portion of their overall revenue.
Certain firms also impose subscription or membership fees. Traders may be required to complete a challenge before they can officially join the program and receive funding, and some companies charge for this opportunity.
This business model, however, is increasingly being phased out due to a significant crackdown by regulators and technology providers.
Drawbacks of Prop Trading
While we’ve highlighted numerous significant benefits of proprietary trading, it’s important to acknowledge its drawbacks:
- Increased Pressure: When trading your funds, you have the autonomy to make decisions without external accountability. In contrast, trading with a prop firm’s capital comes with the responsibility to meet the firm’s expectations and hit performance targets.
- Lack of Stability: Prop firms often have little tolerance for underperformance, swiftly removing traders from the capital allocation program if they fail to deliver results. This can create a volatile and uncertain career environment.
- Upfront Fees: Many prop trading programs require traders to pay membership or joining fees and to pass rigorous “challenges” to participate. These financial commitments can be burdensome, and the qualification process often proves to be a significant hurdle, with many traders failing to secure funding despite their efforts.
How to start Prop Trading?
Entry requirements for joining a prop trading firm can vary greatly. For instance, firms with traders based in physical offices, equipped with state-of-the-art software and hardware, often impose strict requirements. These firms typically have a lengthy screening process and a limited number of positions, as they invest heavily in supporting and training their traders.
In contrast, prop firms that operate remotely and primarily provide traders with funded accounts tend to have more accessible entry requirements. Talented traders find it easier to join these firms, as they face fewer barriers.
Usually, a trader must pay a joining or subscription fee before participating in a challenge or assessment period. During this period, the trader must demonstrate their trading skills with a specified amount of capital, adhering to the firm’s maximum drawdown and profit target criteria. Successful completion of the challenge allows the trader to join the program and potentially receive additional funding in the future.
However, recent regulatory changes are phasing out the subscription fee-based model. As a result, many traders now prefer programs that utilize live trading accounts and do not charge any upfront fees.
Conclusion
Financial firms or institutions typically engage in Prop trading to serve their corporate interests. However, these organizations often operate with thin margins on their products and services due to intense market competition. The revenue generated through Prop trading is crucial in helping them meet their financial objectives.