The world of trading is about more than just trading stocks and other assets on the market. If you’ve been digging into the options, you may have come across a promising alternative in trading— proprietary trading companies. These allow traders to trade on behalf of a financial institution, offering a chance to grow as a trader and boost your career.
But there are two main types — traditional proprietary trading and modern prop trading plateform. In this article, we’ll run through the main differences between the two, including benefits, structure, and operations.
Introduction to Proprietary Trading
Before we dive into the different types of proprietary trading, let’s start off with the basics.
Definition of Proprietary Trading
Proprietary trading, or prop trading, is when financial firms (such as hedge funds or brokerages) use their own capital to trade. This differs from their usual modus operandi, which involves receiving a commission or fees while executing trades for their clients.
Traditionally, they would hire their own traders to work for them in-house. But recently, a new kind of prop trading has emerged where firms offer programs where companies fund external traders to access their capital and trade on their behalf. This is often called modern proprietary trading.
Structure and Operation of Trading Firms
If you’re considering joining a prop trading firm, you’re probably wondering what exactly to expect from them.
Structure of Prop Trading Firms
Prop trading companies generally have an array of traders and analysts on their team to trade in financial markets for them. They will likely specialize in one particular market, such as futures or commodities.
Operation of Modern Prop Trading Firms
Those working for prop trading firms have to work under the financial institution’s framework. This may mean following specific trading strategies, decision-making processes, or a risk management framework.
Differences Between Traditional Trading and Proprietary Trading
While proprietary trading firms trade using the capital of a financial institution, traditional traders use their own capital. Traditional traders may be institutional investors, but they can also be individuals trading at home. Prop trading is solely the domain of larger companies, although they may recruit smaller individual traders.
Capital Allocation
By working for a prop trading firm, traders can access more leverage. The firm will assign them a certain amount they’re allowed to trade, and in return, they get to keep some of the profits. Profit sharing agreements differ — for instance, it could be 80:20 or 50:50 between the trader and the firm.
This gives traders access to more capital than if they were using their own money, leading to greater profit potential.
Risk Management
Since individual traders are often trading with their own money, they’re also responsible for managing their own risks and may have to risk losing their own capital. This can be trader psychology to manage stress.
In contrast, traders in prop firms are trading the capital of the company. The firms often have dedicated risk management infrastructure, such as setting up established limits or developing models to manage risks automatically.
Key Differences Between Prop Trading and Retail Forex Trading
Retail forex trading is particularly popular among individual investors thanks to the potential for profits. If you’re wondering whether to pursue forex trading or prop trading, we’ve summarized the key differences between firms and retail brokers.
Client Fund Management in Prop Firms
Prop trading firms don’t hold funds for their clients. This means there’s no need for a process on how to manage deposits, withdrawals, and other transactions when dealing with client funds.
Instead, prop trading firms can invest this money into their primary trading activities.
Retail forex traders may need to manage client funds and ensure they do so securely and transparently.
Risk Limitation in Prop Trading
Traders take on fewer risks when prop trading since the firms carry the full responsibility for risk management. Of course, if a trader continually loses money for the firm, they may find it difficult to continue their career due to trader evaluation — more on this shortly.
In retail forex trading, individual traders have the responsibility of managing their own risks. For instance, they may need to set up stop-loss orders or diversify their portfolio.
Advantages of Modern Prop Trading
Funding programs for traders give traders the chance to use their trading skills in a place where they have more potential for success. Instead of being limited by their own capital, they can use the funds of the prop trading company, allowing them to make more profitable trades.
They will also have the chance to improve their skills and network, as many companies invest in the ongoing education of their traders.
Benefits of Testing Trading Skills
Trading firms evaluate their traders based on their profitability and risk management, along with other metrics.
Positive evaluations can be a pathway to more favorable capital allocation and a higher profit share, which allows traders to make more money. This is something traditional traders don’t have to go through.
Importance of Trading Training
When traders join a trading program, such as a forex funding challenge program, they have the benefit of joining an importance of trading. This involves learning more about trading strategies, risk management, and analyzing the market. Traditionally, traders have had to take their ongoing education into their own hands.
Challenges and Regulatory Aspects of Proprietary Trading
All countries have their own sets of laws and regulations when it comes to prop trading, but we’ve compiled a brief overview before.
Financial Regulations and Prop Trading Firms
Since firms use their own capital to trade, they often fall outside of securities regulations.
However, there are still some restrictions. For example, in the US, banks can’t participate in proprietary trading. This was introduced after the 2008 financial crisis to reduce risk.
In some countries, there are also capital requirements that require financial institutions to have a certain level of capital reserves, ensuring they can absorb losses. They may also face rules surrounding anti-money laundering (AML) and Know Your Customer (KYC), although these are unlikely to affect traders themselves.
Risk Exposure in Proprietary Trading
Risk exposure is a major risk in proprietary trading.
Some of the risks to manage include:
- Liquidity risk: The risk of being unable to exit a position quickly to avoid losses.
- Counterparty risk: The risk a counterparty won’t fulfill their side of obligations in a trade.
- Model risk: The risk of a strategy, framework, or model failing.
- Human error: The risk of a trader making a human mistake.
Choosing Between Traditional Trading and Proprietary Trading
If you’re torn between traditional trading and proprietary trading, it may help to consider the pros and cons of both.
Proprietary trading may be an attractive proposition for those who lack access to capital and would like to trade larger amounts to have a greater chance of profits. By joining a large firm to become a trader, you’ll also get access to resources and tools that aren’t available to standard traders.
However, even if you’re successful, it’s not an easy job. You’ll be working in a stressful, high-pressure environment where you need to consistently deliver results. Plus, since you’ll be trading the capital of the firm, the company will often take a large share of the profits you generate.
Traditional trading offers a higher degree of independence and flexibility, giving you complete control over trading decisions and strategies. It also has lower barriers to entry and allows you to keep all the profits.
