Proprietary Trading – What is Prop Trading and how does it work?

Last Updated on September 8, 2023

Ever since the 2008 crisis, there has been scrutiny on how banks and financial institutions trade. This lead to establishing the Volcker rule. Its purpose was to safeguard the interests of retail clients. It was a measure to protect them from the volatile trading activities of these institutions. The rule has also regulated proprietary trading activities carried by different types of financial institutions. Individual traders have also started taking up proprietary trading as a profession due to its earning potential. Today, many of these firms are hiring traders to conduct trades on their behalf.

What is Proprietary Trading?

In the context of a bank or financial institution, proprietary or prop trading refers to trading activities carried out using its own money. This means that the firm doesn’t have permission use deposits or other client money to carry out trades that would generate profit for the firm. In a prop trade, since the firm is using its own money, it also bears all of the potential gains and losses.

The departments carrying out any prop trading activity are typically separate and don’t have access to any client funds. The prop trading desk can, however, assist in the market-making activities of the firm. For example, a client can purchase illiquid securities from the prop trading desk. What we need to understand is that the regulations governing prop trading can be rigid. Therefore, most firms ensure that the desk functions independently.

For an independent individual, prop trading involves using the capital of a firm to carry out trades. In this case, the individual acts as an agent for the firmtakes. In return they take a cut of the profits they generate. The firm generally trains the individual and provides the platform for prop trading. Many people have started taking up prop trading as a full-time career. The initial investment is low, and the potential benefits are extensive. The downside is that in many cases there are some limits based on the initial investment the trader puts in. 

In this article we will mainly focus on prop trading carried out by independent individuals. We’ll also look into how someone with the necessary experience could puruse it full-time.

What is Prop Trading and How Can You Become a Prop Trader?

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How Does Proprietary Trading Work?

There are a number of working models for prop traders. Here are a few of them:

Little to no initial investment by the trader

In this case, the trader only bears the training expense and does not have to put in significant money to start trading. The firm takes a larger share of the profit the trader makes. In some cases it can be as much as 50%. Traders may also have to bear additional costs like software fees. Since the trader has limited capital to lose, the personal risk they take is also higher.

Higher initial investment

This arrangement is a variation of the one above. In this case the prop firm expects the trader to provide most of the capital. In return, however, they receive a substantially larger share of the profits. This model is suitable for traders with a higher appetite for risk. Mainly due to the possibility of losing out on the capital that they invest at the start. In this case firms typically absorb 10% of the profits. They may also charge commissions and other fees.

Hybrid model

You could consider this version a mix of the previous two. The trader’s initial investment is substantial and so is their share of the profits or losses. By ensuring equal participation from both stakeholders, this model incentivises more efficient capital use. The way the firm and the trader share the profits and losses are equally helps to properly align their interests. It’s a safeguard against traders pursuing risky trades that could impact their own capital adversely as well.

Advantages of Proprietary Trading

Many argue that there is little reason to work for a prop firm when the profits can be generated simply by using a personal account. There are many advantages of proprietary trading jobs that cannot be realized by simply trading using their own capital. See some of these advantages below:

Access to higher capital base

Earlier we mentioned the prospects of prop trading providing opportunities for full-time employment. This can only be a practical option if the profit the trader generates is of significant value. By deploying one’s capital, a trader may not be able to generate high revenues due to a smaller asset base. Prop trading gives these traders access to more capital. The additional funds that firms are willing to put in paves the way for higher potential returns. This form of trading ensures that the trader does not have to take any leverage that bears fixed costs to generate higher profits.

A lower level of risk

Prop traders, in most cases, only put in a small sum of money. Typically the share of the capital the firms contribute is significantly higher. This ensures that the equity participation of a prop trader is small enabling him to take more risk. This could put the firm at a disadvantage, since it might encourage traders to pursue extremely risky trades. Meanwhile, if the trader were using their own money the might’ve avoided such a strategy. On the other hands, there are typically no caps on profits in this kind of setup.

Lower commissions, fees

When an individual trades for himself, the brokerage fees and commissions may be higher. Prop trades are subject to lower fees because trading costs for firms tend to be lower than those of retail investors. There could be a significant reduction in costs since these trades are carried out frequently and the volumes tend to be higher. Trading for a firm also eliminates or reduces any account maintenance charges for a trader.

Access to training and trading platforms

Because these firms contribute a significant amount of capital, they often also provide training to traders before they even get the chance to trade live. Though in most cases the cost of training is born by the trader, it equips him with the necessary expertise they need to enter the markets. Working alongside other traders in the same firm also adds to the development of a trader who is relatively new to this role. Additionally, the trader gains access to training materials that have practical implications in the financial markets. 

How Can You Find a Proprietary Trading Job?

Many financial firms post their open positions for prop traders in online job portals. Each firm specializes in a specific set of assets ranging from equity to cryptocurrency. Traders with expertise in futures and other derivatives are also in demand. While there is a preference for people with experience, firms are willing to absorb more junior traders into the workforce. At least the ones that provide adequate training. Some of these firms even offer a fixed salary. These can come in two forms. Either the trader does not any share of the gains they generate. In that case they might receive a bonus for good performance. Alternatively they might receive a small base and a commission on their profits.

While most of these jobs can be found in job portals, opportunities for bigger players can be found on their dedicated websites. Prospective applicants should be aware of the salary structure before applying. Some firms provide low fixed compensation along with profit-sharing opportunities. There are many fraudulent postings that require traders to provide an initial deposit with promises of extremely high returns. Candidates should be aware of such schemes and ensure necessary background checks are done before committing any capital. It is also advisable to take the assistance of a reputable job consultant while trying to search for proprietary trading jobs.

Conclusion

Proprietary trading jobs present an opportunity to amplify potential profits using the capital of a firm. It is a low-risk strategy that is gaining momentum among traders. Numerous opportunities are available that give individuals the flexibility to work from home. Now only did we see the volume of such trading grow substantially, but these practices are increasingly incorporating a wider range of asset classes. 

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