Agency Trading vs. Principal Trading: Which Option Is Right for You?

Do you want to be in charge of your own trading destiny, or would you rather have a broker do all the work for you? When it comes to options trading, there are two main strategies: agency transactions and principal transactions. 

In this blog post, we'll break down both strategies and explain the benefits and drawbacks. By the end of this article, you'll be able to make a clear distinction between agency vs. principal trading. Here's what you need to know.

What Is Principal Trading?

Principal trading or a principal transaction is when brokerage firms purchase securities in the secondary market, hold them for a period of time, and then sell them.

The main goal of principal trading is to make a profit on the spread between the purchase price and the selling price. In order to do this, brokerages must have a thorough understanding of market conditions and be able to correctly predict future trends.

One of the key benefits of principal trading is that it allows brokerages to carry out the necessary adjustments in the market by using their own inventory. When utilizing in-house inventory to fulfill client orders, the Securities and Exchange Commission or SEC demands that the principal trader use market prices that are comparable to or better than those available in the open market.

Among the drawbacks of principal trading is the level of risk shouldered by stockbrokers. Brokerages are holding onto securities and making decisions based on their own analysis, leaving them vulnerable to getting caught up in market bubbles and making poor investment choices. 

In addition, principal trading is often done with the client’s money and carries notable fiduciary obligations.

What Is Agency Trading?

Agency trading involves a broker who matches buy and sell orders from different clients without taking ownership of the securities. In agency trading, the broker is an intermediary between the exchanges and the clients. The broker does not take positions in the market but simply executes trades based on the client's instructions.

The benefit of agency trading is that it is much less risky than principal trading, as the brokerage is not exposed to the same level of market risk. Additionally, agency trading is typically available to all investors, regardless of their experience.

However, there are some drawbacks to this type of trading. Since agency brokerages do not control their own inventory, they may not be able to execute trades as quickly as a principal broker.

Additionally, agency transactions are generally less profitable than principal trading, as brokerages earn commissions on each trade.

Differences Between Principal and Agency Trading

Below we’ve outlined a few key differences between agency and principal trading:

- In an agency transaction, the trader does not take on any risk. This means that they are working for the buyer or seller and are not exposed to any market volatility.

- In principal trading, the trader is taking on the risk for their own account. This means that they are exposed to shifts in the market and could potentially lose money if the market moves against them.

- Agency trading is typically used for smaller trades or for trades that are not time-sensitive. Principal trading is typically used for larger trades or for trades that are time-sensitive.

- Agency trading usually has lower commissions than principal trading. This is because the trader is not taking on any risk and is simply acting as an agent.

- Principal trading usually has higher commissions than agency trading. This is because the trader is taking on the risk for their own account and will typically charge a higher commission to offset this risk.

Choosing the right option depends on your individual circumstances. If you are looking to trade large amounts of money or are leaning towards time-sensitive trades, principal trades are the better option. 

If you are looking to trade smaller amounts of money, are not concerned about timing, and are content with smaller-than-average market returns, go with agency trading.

Ultimately, it is important to understand the difference between the two types of trading so that you can make the best decision for your situation.

In Conclusion

The agency model vs. the principal model comparison outlines two different ways of trading. Both have their own sets of advantages and disadvantages. Identifying the most profitable and appropriate option comes down to your individual trading goals and objectives.

Principal trading is better suited for those looking to take on more risk in order to potentially reap higher rewards. Agency trading, on the other hand, is better suited for those who seek lower trading commissions, want to trade with less risk, and are content with smaller potential returns.

At the end of the day, it all comes down to what you as an individual trader are looking to get out of the market. Do your own research and due diligence to determine which option is best suited for you and your trading goals.