Proprietary trading is a kind of market activity that financial institutions can engage in using their own capital, and many recruit dedicated traders to help them. This is a popular way for traders to test their trading skills and maximize profits — but there are a few considerations before diving straight in.
This article runs through an in-depth explanation of proprietary trading, plus the types of firms, market strategies, and career opportunities.
What is Proprietary Trading?
Proprietary trading is a kind of trading where financial companies like investment banks, brokerages, hedge funds, or other financial institutions trade for their own benefit, with their own funds.
This can involve trading any kind of asset, including:
- Foreign currencies
- Stocks
- Bonds
- Commodities (e.g., oil or precious metals)
By doing so, they earn a profit from investing in assets that increase in value rather than making their money through commissions or fees from their customers’ investments.
Definition and Basic Principles
When trading, prop traders can take advantage of market inefficiencies and volatility to earn a profit, using tools and algorithms to look for price movements or trends they can exploit.
Traders generally make speculative investments, and they often use sophisticated tools such as derivatives. It is typically a more advanced type of trading.
Traditionally, these companies had traders as their employees, who would make these investments for them. But the modern age has ushered in a new model, which involves firms partnering with traders outside of the firm, who they recruit to trade for them if they pass an evaluation measuring their trading skills. This is sometimes referred to as modern prop trading.
In both cases, the basic idea remains the same.
Trading with Own Capital
Prop trading firms use their own capital to make trades instead of the capital of their clients, which is what differentiates the practice from other types of trading.
Traders must have a competitive advantage to be able to outperform other traders and effectively “beat the market.” Financial institutions are in a strong position to achieve this compared to individual traders, as they have access to advanced tools, established practices regarding trading strategies and risk management, and can choose the most talented people to trade on their behalf.
They can achieve profitability using a range of strategies, which we will explore shortly.
Differences Between Proprietary Trading and Client Trading
As we’ve seen, the main difference between proprietary trading and client trading is that client trading involves using the clients’ funds to make trades while earning a commission from clients (or charging them fees). Meanwhile, prop trading involves using the firm’s own capital to make trades, allowing the company to keep all the profits.
Prop trading also involves more stringent regulations and greater risks.
Why Do Financial Institutions Engage in Proprietary Trading?
The main reason financial institutions opt for prop trading instead of client trading (or in addition to) comes down to competitive advantages and the high profit potential.
Competitive Advantages
Although traders need to have a competitive advantage when trading in the market, firms gain a competitive advantage through their involvement in prop trading. For more insight into how these firms operate and differ from traditional trading, explore the distinctions between prop firms and retail brokers.
When they hold speculative inventory by stockpiling securities, it can benefit their clients by acting as a buffer against price swings.
When the market goes down or faces illiquidity and it’s harder to buy or sell on the market, firms will already have their own inventory in place to fall back on.
The financial firm may even be able to become a market maker, meaning they can provide the market with liquidity for a certain security by being able to buy or sell it. This gives a firm the chance to earn commission through the bid-ask spread from trades, and they also receive compensation in return for the risk of being a market maker.
High Profit Potential
The main reason for financial institutions to opt for prop trading is to boost their profits compared to other types of trading, like index investing or bond yield appreciation. For those looking to start a career in this high-reward field, check out how to secure a spot at a top prop firm for practical advice.
While financial institutions already have the chance to earn money through commission or fees when they trade on behalf of their clients, this approach only allows them to make a very small percentage of gains made (typically 1% or less of the amount invested).
In contrast, prop trading offers the opportunity to earn up to 100% of the profits. As a result, it can be worth taking on some of the risks involved.
Also, since they’re trading their own money and not the funds of clients, traders can afford to take more risks.
But as with all types of trading, profits are never guaranteed — prop trading is a risky venture and there’s always the chance of making a loss. This is why firms carefully vet their traders and try to only take on the most skilled.
How Does Proprietary Trading Work?
Now we’ve explained the basics of prop trading, let’s take a more detailed look at how it works.
Trading Strategies Used
Prop trading companies can use trading strategies such as:
- Statistical arbitrage (uses mathematical models and algorithms to find price discrepancies)
- Volatility arbitrage (takes advantage of mispricings between option prices and actual price fluctuations)
- Global macro trading (makes trends based on macroeconomic trends)
- Momentum trading (focuses on stocks with a positive recent performance)
Role of Proprietary Trading Desks
A proprietary trading desk uses the capital and balance sheet of the firm in question to carry out transactions that are “self-promoting” (meaning they are in the interests of the financial firm rather than the interests of the client).
As mentioned already, trading desks may also become market makers by acting as a buyer or seller among traders in the market that want to trade a security that’s low in liquidity.
Importance of Autonomy in Trading Desks
It’s important for the desk to be separate from other trading desks in the form for the interests of the other clients, so that independent trading decisions can be made instead of using clients’ money.
Types of Proprietary Trading Firms
Now, let’s look at a few different types of prop trading companies.
Independent Firms vs. Brokerage-Based Desks
So far, we’ve focused on brokerage-based desks, which are brokerages that generally trade for clients but open a dedicated desk for proprietary trading to broaden their services. Their traders are typically employees who earn a salary.
Meanwhile, independent firms are companies that were set up specifically for proprietary trading. These companies tend to have a more entrepreneurial, risk-taking approach and to offer profit share agreements to their traders.
Forex Trading Firms
Prop trading is popular in the world of forex trading, which involves earning a profit by exploiting fluctuations in exchange rates or the values of different currency pairs. For a deeper understanding of how these firms navigate global markets, see an overview of prop trading in the UK.
Futures Trading Firms
Futures contracts are contracts that commit a trader to buying or selling securities (such as commodities, indices, or financials) in the future. Since futures contracts are one of the riskier trading markets, firms must be careful to manage their risks — but there’s also high potential for profits.
Stock and Options Trading Firms
Options are contracts that give a trader the right to buy or sell an asset at a specific price in the future. Prop trading firms focusing on stocks or options use the resources of their company to take advantage of volatility in the market and make predictions. For instance, they may use technology like AI or advanced charting to help them make the right decisions.
Cryptocurrency Trading Firms
The cryptocurrency market may be newer than those outlined above, but it has now become a staple in the proprietary trading industry, with some firms now specializing in this area. As a highly volatile market, it can be more high-risk but high reward.
It can involve the main cryptocurrencies like bitcoin or ethereum, as well as newer, more niche digital coins.
Regulation and Restrictions on Proprietary Trading
The exact regulations and restrictions surrounding proprietary trading vary between countries. However, since prop trading involves firms investing their own funds, it faces fewer regulations than client-focused financial activities.
Companies that are broker-dealers must register with the SEC and FINRA in the US. However, companies that are a member of a national securities exchange and don’t have customer accounts do not face regulations.
This excludes many modern prop trading firms from regulators, but this “loophole” is already on the radar of regulators and may change in the future.
Restrictions for Large Banks
In the US, the Volcker Rule prohibits banks from taking part in proprietary trading to protect the money of their clients.
Strategies and Techniques Used by Proprietary Traders
Every trader may have their own unique approach to prop trading, but there are a few strategies and techniques that are common in the world of prop trading.
Arbitrage
Arbitrage involves trading price differences between assets. For instance, you might buy a stock at one price on one exchange, then sell it for a higher price on another exchange. However, pure arbitrage is rare — instead, most traders focus on trying to identify possible price convergences.
Quantitative Strategies
Quantitative strategies use mathematical trading models and algorithms to automatically execute trades. The models therefore have different patterns and strategies built into them, and can use them to make decisions on behalf of traders at high speeds.
Comparison between Proprietary Trading and Hedge Funds
Although proprietary trading and hedge funds share some similarities, they differ in many key dimensions, as detailed below.
Capital Utilization
While proprietary trading companies use their own funds for trading, hedge funds pool together the capital from other investors to create an investment portfolio. These funds may come from companies, private investors, or other entities.
Risk and Reward Management
Prop firms give a chunk of the profits from trading to traders themselves, meaning there’s a potential for high rewards (although the split may be weighted toward the firm).
Meanwhile, hedge funds traditionally charge a 2% asset management fee and 20% performance fee. However, some funds do offer lower fees to remain competitive.
Prop trading tends to take a riskier approach due to a focus on short-term trading and profitability. For instance, they may use more leverage or trade riskier securities such as options or futures contracts.
While hedge funds also take on risk, they engage in more risk management and have dedicated accountability structures.
However, prop trading firms are also proactive about mitigating risks, which they may achieve by setting their own guidelines or diversifying their portfolio.
Investment Time Horizon
Generally, prop firms focus on the short-term, although this can range between periods lasting less than a minute to positions held over multiple days. However, the primary focus of this type of trading is generally finding price discrepancies to exploit.
Hedge funds invest over a wider range of time horizons. They often also use short-term strategies, but these are often combined with medium-term or long-term strategies. This may vary depending on the investors.
Trading Strategies
Since both hedge funds and prop trading firms aim to make a profit through trading, they often use similar strategies.
These may include:
- High-frequency trading (HFT): Using powerful algorithms to execute trades at high speeds to take advantage of price differentials.
- Interest rate trading: Aiming to predict movements in interest rates to earn a profit.
- Long/short equity trading: Taking long positions in stocks expected to rise in value, or short positions on stocks expected to decrease in value. This may involve sophisticated analysis.
Flexibility and Regulation
Since hedge funds manage the capital of clients, they are subject to more regulation than prop trading firms. Often, they must register with regulatory authorities and provide reports on their investment performance (depending on their jurisdiction).
Proprietary trading has evaded a lot of regulation since the companies invest their own money instead. However, they have been subject to more scrutiny in recent years, and firms must meet certain capital and reporting requirements.
Career Opportunities in Proprietary Trading
When it comes to career opportunities in proprietary trading, there are two main options — getting a job at a proprietary trading firm, or joining a dedicated program.
Required Skills and Qualifications
Naturally, the greatest skill needed to become a prop trader is to be a capable trader. You’ll generally need a broad knowledge base of the theory behind trading, including market mechanics, trading strategies, risk management, and financial instruments.
Rather than assessing any particular qualification, firms will be interested in seeing your track record and assessing your skills for themselves. This might include trading simulations or live trading accounts.
Career Prospects and Benefits
A prop trading career offers the potential for high earnings through profit-sharing arrangements. It also tends to be a meritocratic, achievement-based field with a high degree of autonomy.
Challenges and Competitiveness
Prop trading is a competitive field. Companies have high expectations, and you will be competing with a large pool of people who all want the same opportunities.
Obtaining a position may also involve interviews, psychometric testing, and background checks.
Best Proprietary Trading Firms for Beginners
Getting into prop trading can be a daunting prospect for beginners, but we’ve summarized some of the most popular programs below.
Training and Mentorship Programs
Challenge4Trading is a leading proprietary trading firm, recognized for providing traders with the best opportunity to showcase their skills without risking their own capital. With a carefully structured program, traders start in a simulated trading environment, proving their abilities through a series of well-designed challenges. Successful participants then progress to managing real funds, positioning themselves for a successful long-term career in trading. Challenge4Trading stands out by offering unparalleled performance feedback and mindset coaching, ensuring that traders not only refine their strategies but also develop the resilience needed to excel in the markets. For those serious about trading, Challenge4Trading is the best choice for growth and success.
Topstep Trader has a strong emphasis on developing the skills of its traders. As well as a partner program that promises to help its participants earn competitive commission, it offers coaching. This follows its own unique Prep–Trade–Reflect® approach to help traders learn over time.
Funded Trading Plus originally began as a trader education platform, meaning that it has an in-depth understanding of what beginners need to succeed. While its programs aren’t suitable for complete beginners (the lowest level is for experienced traders), it can help those who are new in the game to boost their skills.
FTMO is a modern prop trading firm that has a popular program for beginners. It has an evaluation process that requires traders to participate in the FTMO Challenge to show some basic skills, after which they are asked to manage funds in a demo environment. If successful, you can progress to the Premium Program, which has a contract with a fixed salary and can ultimately lead to a fruitful trading career. Participants will also get their own performance and mindset coach.
Cost and Profit-Sharing Models
Every proprietary trading firm sets its own structure for charging (and paying profits to) traders, but there are some common themes.
Most companies will charge you to join their program and participate in an evaluation. While this might sound unfair at first, it’s designed to cover the cost of someone monitoring you and allowing you to use the trading account. This could cost up to $1,000 in some cases.
Some companies also charge monthly subscription fees for using their prop trading platform.
As for profits, most companies offer a fixed percentage split. In this case, you’ll receive a percentage of the profits you generate — for instance, you receive 10% while the firm gets 90%. This may increase over time as you prove yourself and generate more profits.
