What Is Prop Trading? [Full Guide for 2024] - Review42 (2024)

If you’re wondering what prop trading is, you’re not alone. The term is often tossed around in the financial world, and it can be confusing.

In this article, we will break down what is prop trading and how it works. We’ll also discuss the pros and cons of prop trading and compare it to hedge funds. If you’re thinking about starting your own prop trading firm, we’ll give you some tips on how to get started!

What Is Prop Trading?

Prop trading, short for proprietary trading, is a type of trading that is done within a financial firm or a commercial bank. Prop traders use the firm’s money to trade financial instruments, such as stocks, bonds, or commodities. The goal of prop trading is to make a profit for the firm. Prop traders don’t work for external clients, but rather handle the investments of the firm itself.

Such trading occurs when a financial firm chooses to profit from market activities, rather than relying on thin-market commissions obtained through client trading activity.

What Is a Prop Trader?

A prop trader essentially uses a firm’s money to invest in assets like stocks, bonds, and commodities. In some arrangements, a prop trader provides a part of his capital to the firm to guarantee that he has the firm’s best interest in mind and is not involved in extremely risky trades.

Becoming a prop trader is a good career option as it does not involve strict working hours. Moreover, the profits are split between the firm and the prop trader in a pre-decided ratio. Each trader has their own unique way of trading. Some focus on index investing, while others focus on bond yield appreciation.

Traders often use the help of professional software and stock market indicator tools to excel in trading!

DID YOU KNOW: Keeping in mind the future of crypto, prop traders have also started trading in cryptocurrencies!

How Does Prop Trading Work?

Now that we’ve understood what proprietary trading is, let’s see how it works.

Prop traders use the firm’s money to conduct a transaction. This means that the firm takes on all the risks. Prop traders are usually given strict guidelines by the firm on how much they can trade and what types of trades they can make.

Moreover, the firm that a prop trader works for will give them a set amount of money to trade with. The trader will then use this money to buy and sell financial instruments. Firms don’t keep the full profit; they only keep a percentage of it and the rest goes to the trader.

Pros and Cons of Prop Trading

Our proprietary trading definition and overview would be incomplete without mentioning the pros and cons of prop trading.

Let’s first understand its pros:

Direct Market Gain

When financial institutions trade for external clients, they only earn a small percentage of the client’s money as commission and fees. This revenue may not be enough for financial institutes to actually earn a significant profit. However, prop trading allows firms to keep most of the profits they receive from trading and get a higher annual return.

A Stockpile of Inventory Securities

When a prop trading firm buys securities, they create a stock of inventories with the expectation that their value will rise over time. This stockpiling of proprietary investments can provide a cushion for the firm during market downturns. Moreover, these investments allow the firm to offer unexpected advantages to its clients.

Allows New Investment Ideas

Since prop trading firms are not working for clients, they can take more risks with their trades. This allows them to test out new investment ideas and strategies.

Influential Market Maker

Prop trading firms often become market makers for the securities they trade. This means that they provide liquidity on specific security or group of securities to the market and help to set prices, giving these firms a competitive advantage.

Now let’s look at some of the cons of prop trading:

High Risk

Prop trading is a high-risk activity, and the firm can lose a lot of money as well as proprietary assets if the prop trader is unsuccessful. To reduce the risk, prop traders must know the ways to research stocks as well as which cheap stocks to buy so they can sell them at a profit later.

Volatility

Most prop trading is done as day trading, that is, traders buy and sell stocks on the same day. This can make this trade type very volatile and the firm’s profits can fluctuate greatly from month to month.

DID YOU KNOW: The Volcker Rule is a regulation that prohibits banks from engaging in certain proprietary trading! However, prop trading firms are not subject to the Volcker rule, making them free to trade!

Key Takeaways

Prop Trading vs Hedge Fund

People often get confused between prop trading and hedge funds. Here are some key differences between the two:

Ownership

In hedge funds, the funds are owned entirely by the investors, and fund managers and their colleagues manage these funds on behalf of the investors. In prop trading, the funds are managed by the financial firm itself.

Profitability

Hedge fund managers earn by charging a commission from the investors. The commission fee can be very high or low depending on the fund manager’s experience level as well as the strategies of the hedge fund used. In a proprietary model, firms get 100% profit when they are trading on their own. They may also share the returns with the prop traders.

Risk

Hedge funds are subject to more regulations as they’re handling investments on behalf of their clients. This means that they can take on less risk. Prop trading firms can take on more risk because they are not bound by the same regulations.

DID YOU KNOW: Hedge fund companies do not have any investing limits and they can invest any amount they’re comfortable with. They also invest aggressively in all sorts of financial markets!

How to Start a Prop Trading Firm?

If you’re thinking about starting your own prop trading firm, there are some things that you should pay attention to as they will prove to be very important in running your firm. Here are some of them:

Capital

You will need capital to trade with. The amount of capital you need will depend on the size of your transactions and the level of risk you are willing to take.

Trading Strategies

You will need to have developed trading strategies that you are confident in. They should be based on sound risk management and a thorough understanding of the markets.

Technology

Starting a prop trading firm requires proper research and understanding of the technology you’ll use for trading. This includes your trading platform, your broker’s systems, and any other software you use.

There are several good prop trading firms that you can research before starting your own. Make sure you understand the risks and have a solid plan for managing your firm!

Conclusion

Prop trading is a type of trading that is done by firms using their own proprietary capital. Prop traders do not work for clients; they speculate on behalf of the firm. The goal of prop trading is to make money for the firm. Prop trading has a number of advantages, including the ability to test new investment ideas and the ability to become an influential market maker.

However, it also has its own disadvantages, including high risk and volatility. If you are thinking of starting a proprietary trading firm, make sure you understand the risks and have a solid plan for managing them.