Prop trading

Quick definition

By:

James Knight

James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.

Reviewed by:

Idil Woodall

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Updated: Aug 1, 2023

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Prop trading is a financial trading strategy where firms or individuals use their own capital to speculate on financial instruments with the aim of generating profits.

3 key takeaways

• Prop trading is when a company or an individual use their own capital to conduct trades in financial markets
• They aim to make profits for the firm or the individual themselves, rather than acting as an intermediary for clients
• Prop trading firms often offer profit share incentives to encourage quality traders to work for them

What is prop trading?

Prop trading, short for ‘proprietary trading’, refers to a financial trading strategy where a firm or individual trades financial instruments, such as stocks, bonds, currencies, commodities, or derivatives, using its own capital rather than client funds. Prop traders make trades with the goal of generating profits for the firm or individual themselves, and they employ various trading strategies and techniques to achieve their objectives.

How does prop trading work?

A prop trading firm provides professional traders with the capital to speculate on financial markets and then splits the profits with them. The success of prop trading largely depends on the trader’s ability to identify profitable opportunities and manage risk effectively. Proprietary trading firms may specialise in certain markets or trading styles, such as high-frequency trading, quantitative trading, or event-driven strategies.

Once a trader is hired, they will be given a certain amount of capital to trade with. The trader is then responsible for generating profits from their trading activities. If the trader is successful, they will share in the profits. However, if the trader loses money, they will be responsible for the losses.

Here’s a brief rundown of how the best prop trading firms operate:

1. The firm recruits experienced or aspiring traders with proven track records or potential. They may provide training and resources to help those traders develop their skills and trading strategies.
2. The company provides capital to the traders for conducting trades. Each trader is allocated a specific amount of capital, often referred to as a “trading account” or “trading book.” The capital allocated to each trader varies depending on their experience and success rate.
3. Traders use various strategies to identify potential opportunities in the markets. These strategies can range from arbitrage and market making to directional trading and statistical arbitrage.
4. The firm implements robust risk management systems and guidelines to manage the inherent risks associated with trading. These systems help their traders stay within predetermined risk limits to protect the firm’s capital from excessive losses.
5. Traders’ performance is closely monitored and evaluated based on their trading results. Successful traders are often rewarded with a share of the profits they generate, commonly referred to as a “profit split.”
6. After deducting expenses, such as trading costs and overhead, the remaining profits are shared between the company and the traders based on predefined profit-sharing arrangements.

What are the benefits of prop trading?

The potential for higher profits combined with the reduced risk of trading with the company’s money rather than your own are the main benefits for each individual trader. Prop trading firms provide traders with access to significant amounts of capital to trade with. This allows traders to take larger positions and potentially generate higher profits than they could with their own limited funds, while the risk is somewhat shifted towards the company instead of to the individual.

Another benefit is that prop traders often have more freedom than traders who handle client funds. There are more restrictions on traders who manage funds of external capital, as they may have to follow a set of criteria or meet the demands of their clients. Prop traders, on the other hand, use their own firm’s money, so they can take more risks and adapt quickly to changing market conditions.

In addition, traders are often incentivised based on their performance through profit-sharing agreements. Successful traders can earn significant bonuses and a share of the profits they generate, providing strong financial incentives for them to excel in their trading activities.

Can banks engage in prop trading?

Generally no, although the regulations vary across different countries. After the global financial crisis of 2008-2009, regulatory authorities in some countries imposed restrictions on banks’ prop trading activities to reduce excessive risk-taking and potential conflicts of interest.

In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law in 2010, included the Volcker Rule. The Volcker Rule prohibits insured depository institutions, which include most commercial banks, from engaging in proprietary trading for their own profit. It aims to separate traditional banking activities from risky speculative trading.

However, it’s worth noting that certain banks may still be allowed to engage in some form of proprietary trading through separate entities that are not covered by the same regulations as their traditional banking operations. These entities are often subject to stricter capital and risk requirements to mitigate potential systemic risks.