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.

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? ›

Key Takeaways: Proprietary trading refers to a type of employment in certain commercial companies that entails utilising only the company's funds for trading in the financial markets. The concept of prop trading offers advantages such as risk management, educational support, coaching, and automation, among others.

What are the benefits of prop trading firms? ›

Access to Capital: One of the most significant advantages of joining a prop trading firm is the access to the company's capital. Traders can leverage the firm's funds, which allows them to take larger trading positions than they could afford with their own capital. This can potentially lead to higher profits.

What is the purpose of propriety trading? ›

Proprietary trading involves a firm deploying its own capital, leverage, and resources to invest, trade, and speculate in financial markets, including stocks, bonds, currencies, commodities, and derivatives. The objective is to generate profits from the firm's own market positions and trading activities.

What is proprietary trading advantages and disadvantages? ›

At the end of the day, the main advantage of proprietary trading is leverage, and the main disadvantage of proprietary trading is fraud.

Is proprietary trading good? ›

Proprietary trading provides many benefits to a financial institution or commercial bank, most notably higher quarterly and annual profits.

Do prop traders make good money? ›

Senior Traders often earn between $500K and $1 million, and Partners can earn over $1 million per year. Base salaries do not necessarily change that much as you move up, so most of these gains come from increased bonuses.

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 trading 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.

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 pay? ›

Earnings of Prop Trading Firms

Prop trading firms generate revenue through various sources such as commissions, fees, and profits from their traders' activities. These earnings are then distributed among the firm's partners and traders according to a predetermined compensation structure.

Can you make a living prop trading? ›

As a result, anyone can be profitable as a prop trader because profitability is linked to their experience and skills, strategy, and ability to generate gains by trading in the market with the firm's capital.

How much do proprietary traders make? ›

The average prop trading salary in the USA is $210,000 per year or $101 per hour. Entry level positions start at $146,300 per year while most experienced workers make up to $250,000 per year.

What happens if you lose money in prop trading? ›

When you are trading with a prop firm, your losses are usually limited to the foregone risk of your challenge/account fee. You are generally not liable for the prop firm's lost funds.

Do I need a license to prop trade? ›

Do proprietary trading firms need a license? Prop trading firms are less heavily regulated than regular brokerages and broker-dealers. However, if such laws apply, you must still properly register your business and get licensed.

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? ›

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.

Is working with a prop firm worth it? ›

Is working with a prop firm worth it? There are many unique advantages that make working with a prop firm worth it. These include access to unique software and information, trading with the firm's capital, and cashing in a large portion of your winnings.

What are the negatives of prop firms? ›

- Traders in prop firms often have limited control over the firm's capital. They may need to deposit their own money as collateral or risk management. - Additionally, payouts are subject to the firm's rules, which may restrict a trader's access to profits.

Why do prop traders make so much money? ›

Access to Capital: Prop firms provide traders with access to capital that they may not have on their own, allowing them to make larger trades and potentially earn higher profits.

How much do prop firms pay traders? ›

Base salary: Most prop trading firms offer their traders a base salary, which is usually paid on a monthly or annual basis. This salary can range from $50,000 to $100,000 for junior traders and can go up to $500,000 or more for senior traders.

Top Articles
Latest Posts
Article information

Author: Sen. Ignacio Ratke

Last Updated:

Views: 5631

Rating: 4.6 / 5 (76 voted)

Reviews: 91% of readers found this page helpful

Author information

Name: Sen. Ignacio Ratke

Birthday: 1999-05-27

Address: Apt. 171 8116 Bailey Via, Roberthaven, GA 58289

Phone: +2585395768220

Job: Lead Liaison

Hobby: Lockpicking, LARPing, Lego building, Lapidary, Macrame, Book restoration, Bodybuilding

Introduction: My name is Sen. Ignacio Ratke, I am a adventurous, zealous, outstanding, agreeable, precious, excited, gifted person who loves writing and wants to share my knowledge and understanding with you.