What is Prop Trading & What is a Proprietary Trading Firm?

Do you think your stockbroker institution does not participate in the stock market with all the information available to them? Then you might need to pay a little more attention to what is happening around you. 

It is called Proprietary trading or prop trading, where the firm takes all the risk for trading the financial instrument, and consequently all the profits.

It’s not the best thing to see when you entrust your money to an institution and they can trade it away, just like major banks in the USA did with speculative investing, leading to the 2008 financial crash.

This crash had repercussions all over the world as economies are dependent on each other to varying degrees and thus not immune to such global ‘black swan’ events.

What Does Proprietary Trading mean?

proprietary trading

Proprietary trading is when a financial institution uses its capital to directly invest in the market. I used to think that the major way stock broking companies made money was from the trading fees charged to their customers. Couldn’t have been farther from the truth.

This can include stocks, derivatives, bonds, commodities, or other financial instruments limited only by any possible conflicts of interest between the institution’s fiduciary responsibility to its customers and its profit-making aspirations. 

The trading can be either bi-directional or market-making. Directional trading involves betting that a security’s price will increase and positioning your trade accordingly.

On the other hand, if you think the price will decrease, you take a short trade. Market-making is when the trading firm acts as both the buyer and seller at different times. This allows them to make money on the bid-offer spread.

Firms that are looking to invest in the open market have the edge over retail investors like you and me just by the virtue of having more information about the market, sophisticated modelling, and advanced trading software.

Many of these technologies are developed in-house and are never used outside the firm itself. This gives firms a competitive advantage over their peers and of course retail investors. 

This kind of trading exists at hedge funds, asset management firms, and commodities companies that deal with their respective security markets on a daily basis and only need to create a separate trading desk for prop trading. 

The biggest banks in the USA used to have them too before being excessively and some would say criminally speculative in the markets and losing their customers’ money. This led to the creation of the Volcker rule which is described in the next section.

What Is a Prop Trading Firm?

A prop trading firm looks for talented individuals and traders that can do the trading for them. This is in addition to having full-time employees that also do this job.

They fund the accounts of these traders ranging from $500 to millions of dollars depending on their proficiency. The firm also provides any kind of specialized training for the trader to ensure that they make the maximum profits. 

The deal between the firm and the trader is one of splitting the earned profits. These percentages can vary from between 20%-50% of the profits depending on where in the trader tier you are.

As you get better, the funding in your account grows, and hopefully, so do your profits. Consequently, the percentage split of profits increases in your favour. 

When proprietary and client orders are placed at a single firm, the proprietary trading desk is almost always cordoned off from the client trading desk to make sure that there is no information passed between the two.

This would create a conflict of interest between the two desks where the profits of the company and the depositors are at odds with each other.

After the 2008 financial crash in the USA, regulatory bodies enacted the Volcker rule as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule is named as such because it was enforced on the suggestions and arguments of the former chairman of the Federal Reserve, Paul Volcker.

This rule makes it necessary for banks to make decisions that directly impact and benefit their customer and not the institution itself. If they are investing for the long term, firms may buy and stock an inventory for a future time when they can sell it for a profit. 

Some firms also use their proprietary trading algorithms and charting tools to ensure the best outcome for the traders. At these companies, traders are under strict rules that include but are not limited to daily loss % and drawdown limit. Because the funding comes from the prop firm itself, they hold the right to let go of the trader if these rules are not adhered to.

Best 5 Prop Trading Strategies

  • Volatility Arbitrage

This strategy entails taking advantage of the difference in the implied volatility of the options and the corresponding move in the underlying security. 

Because the volatility and options prices are inversely correlated to each other, if you feel that the current implied volatility is low and you expect it to be higher in the future, you would take a long call option and take a short position in the underlying.

It is always possible that an unforeseen event might drastically skew the numbers against the trade that has been taken. This can affect even the best of traders and is part of the risk inherent in the trading markets.

  • Merger Arbitrage

This strategy involves buying shares in the companies that are about to merge and focuses on the event of the merger rather than the rest of the market around it. Also known as risk arbitrage, traders who make such investments are known as arbitrageurs.

For example, Company B’s shares are trading at $30/share, and it announces that it will be acquired by company A in a month at the cost of $70/share.

As an arbitrageur, you would buy shares in company B after assessing the risks involved in the possibility of the merger being completed. As the date of acquisition draws near, the price of B’s shares will most probably be higher than the price you paid for it. Hence profit! 

  • Index Arbitrage

When the price of a security is different on two or more market indices, this indicates an index arbitrage trading opportunity. To take advantage of this, you would buy the security on the lower-priced exchange and sell where the price is higher, hence pocketing the difference.

These trades might seem like a trader is ‘taking advantage of the market but this is how exchanges tend to regain equilibrium with the others.

In reality, this work is done by computers that are algorithmically looking for arbitrage opportunities and setting buy and sell orders in the order of milliseconds. They are few and far between so it is not possible to track and take advantage of them manually.

  • Global Macro-trading

After analyzing the current state of the world for the security that is being looked at, a team of traders can come up with an educated guess on, for example, the price of wheat in the next two years. This enables them to take a trade with conviction and be ready with a thesis in case the decision is questioned.

The downside of this approach is that everyone in the world at your level is making similar ‘educated guesses’ and as they say in trading circles, a crowded trade is mostly not a safe trade. 

For example, if a trader or firm had prior knowledge that two countries that produce and export most of the world’s oil would go to war with each other, you would take long positions on the price of this commodity. If the war did happen it would affect the prices hopefully, in the direction of the trade, and you can keep the profits.

  • Chart pattern analysis or technical analysis

technical analysis

This is a basic trading tenet but most traders will look to it for confluence with their other trading theses and hence confidence in the trade. 

Depending on the time frame for the trade, you would look at the charts and map out trends, support, and resistance levels. Additionally, chart patterns, oscillators, moving averages, volume, and momentum indicators are used.

For the most part, the technical analysis of a trader gets better with time spent in the market. This is because TA is based on the assumption that the happenings of the past tend to repeat themselves.

It is also the study of liquidity and order books to see at what prices the orders are placed. Market makers tend to use these studies to their advantage as they have more money at their disposal compared to regular retail investors.

What Is a Forex Prop Firm?

Forex trading is the practice of buying and selling foreign exchange currencies with the intention of making a profit. As it is one of the more volatile markets, skilled traders can make a lot of money with it if they can take advantage of the volatility. 

Forex is the second largest marketplace after the stock market and hence is naturally cornered by large companies where traders do this as a full-time job. 

Forex prop firms will also fund your trading account depending on whether you are a beginner or an expert and then split the ensuing profits with you.

This is much better than using your own capital to make money in this market. After gaining confidence from being a successful paper trader, the next step is to dip your toes in the market with an average of $1000-$2000.

Now imagine that you have a corpus of $50,000 to make your trades. Even with a 10% gain, you can make $5,000 a month which is much more than the $100 you would have made with the $1000 initial investment.

This is where forex prop firms come in, fund you the required $50,000 and make commissions off of your profits, for a minimal fee. Most top-tier companies need you to pass an evaluation test to make sure you understand the market you are getting into, and before they go ahead and give you a trading corpus to work with.

Some things you need to take care of when you’re zeroing down on your forex prop firm of choice are the evaluation phases, daily drawdown limits, overall drawdown, profit criteria, minimum required trading days, and whether they have a weekend trading option.

For beginners, firms like TopStepTrader, Uprofit Trader, and MyForexFunds are useful as they work with beginners and teach them good risk-management tactics so that they can build themselves up. 

For traders that are more confident and just need the capital to start their forex profit-making journey, firms like E8 Funding, SurgeTrader, and Fidelcrest offer the best options and a larger number of currency pairs to trade with. As an experienced trader, they require you to adhere to strict platform guidelines but in turn, give you a much better share of the profits.

Conclusion

Be it the stock or commodities market, prop trading represents companies that are willing to risk their own capital in taking trades in the open market. Such firms keep all the profits they generate and this is in addition to any commission or fees.

For jobs in the domain, you should look into independent firms like Jane Street, Hudson River, Optiver, Tower Research, and Virtu.

If Forex prop trading firms are more your speed, TopStep, SurgeTrader, and FTMO are some places to start.

To be able to land a full-time job at such a firm is essentially the foot in the door that can help you learn with more experienced peers and get access to larger trading capital. 

A con that you should understand if you are willing to give this a shot is that you are entering a hyper-specialized market and a lot of the skills learned here do not transfer to other jobs. On the other hand, the median salary for a prop trader is $203,679.

nv-author-image

Jack Bailey

I am John, a veteran trader turned into a trading coach. Especially in the realm of cryptocurrency derivatives which is now booming and expected to grow big.