Proprietary Trading: What Is It and How Does It Work?

Written By
Julija A.
August 04,2023

Proprietary trading, or prop trading, is a type of investment that is growing in popularity. But what is it, and how does it work? 

In this article, we will discuss what proprietary trading is and take a look at the pros and cons of this type of investment. We will also provide a few examples to help illustrate how it works. Finally, we will explore who proprietary trading is for and why it has become so popular.

What Is Proprietary Trading?

Proprietary trading refers to a type of trading that involves using the firm’s own money to trade financial instruments. The main aim of proprietary trading is to make a profit for the firm that is higher than what the company would make by investing their client’s money. 

Traders may use various strategies, including buying and selling stocks, options, and other derivatives. Proprietary trading is a high-risk, high-reward activity. Because traders are using the firm's money, they have the potential to make a large profit. However, they can also lose a lot of money if their trades don’t pan out. 

As a result, proprietary trading companies typically only hire experienced traders with a proven success track record.

Proprietary trading can be an exciting and lucrative career for those with the right skills and experience. Before pursuing a career in proprietary trading, be sure to research the risks and rewards involved.

Proprietary Trading Types and Strategies

There are a few different options and prop trading strategies you can use to make a profit. Here’s what they are:

Principal Trading

Principal trading is the most common type of proprietary trading. In this strategy, firms trade financial instruments using their own capital with the aim of making a profit. Traders may use a variety of strategies, including buying and selling stocks, options, and other derivatives.

Principal trading can be very risky, but it’s also a very profitable business. In order to be successful, firms need to have deep pockets and a high tolerance for risk. They also need to be able to move quickly, since the markets they trade in can be highly volatile.

Market Making

Market making is another type of advanced proprietary trading. In this strategy, firms provide liquidity to the market by buying and selling securities. Market makers play an important role in the financial markets by ensuring that prices are fair.

They make money by earning the spread between the bid and ask price of a security.

Suppose a market maker is quoting a stock at $20.05/$20.06. This means that the market maker is willing to buy the stock from you for $20.05 and sell it to you for $20.06. The difference between the two prices, or the spread, is how the market maker makes money.

To be successful, market makers must have a deep understanding of the securities they trade and the markets in which they trade them. They also need to be able to react promptly and efficiently to market changes.

Automated Trading

Automated trading is a type of proprietary trading that uses automated software algorithms for trade execution. In this strategy, firms develop computer programs that automatically buy and sell securities based on certain conditions.

For example, a proprietary trading firm may develop a program that automatically buys shares of a stock when the price falls below a certain level. Automated trading is a very popular proprietary trading strategy because it can be executed quickly and efficiently.

However, automated trading is also a high-risk activity. This is because computer algorithms can make mistakes, and when they do, it can cost the firm a lot of money.

Pros and Cons of Proprietary Trading

Now that we’ve seen a few different types of proprietary trading, let’s take a look at the pros and cons of this investment method.

One of the main advantages of prop trading is that it can be very profitable. Because proprietary traders are using their own capital, they have the potential to make a lot of money if successful.

Firms that engage in proprietary trading believe their knowledge of the markets will give them an edge when investing, allowing for higher profits from market activities.

The downside is that it can be very risky and lead to significant losses. Because firms are using their own money, they stand to have higher losses. This is why it’s crucial to have a solid risk management strategy in place before trading.

Also, prop trading can take away from the firm’s core business activities. If a trader is focused on prop trading, they may not be able to devote as much time to the firm’s other clients.

Proprietary Trading vs. Hedge Funds

For the uninitiated, prop trading and hedge funds may seem like two sides of the same coin. After all, both involve investing other people’s money in the hopes of generating a profit. However, there are some key differences between these two types of firms.

Prop trading firms, also known as proprietary trading firms, trade for their own account. That is, they use their own capital to buy and sell securities.

In contrast, hedge funds raise money from outside investors and then invest that capital in a variety of assets. Hedge funds are also much more likely to use complex investment trading strategies, such as short selling and leverage.

As a result, proprietary trading firms tend to be more nimble and aggressive than their hedge fund counterparts. While there is no surefire way to make money in the financial markets, understanding the difference between prop trading and hedge funds can help you make more informed investment decisions.

The Volcker Rule in Proprietary Trading

The Volcker Rule is a set of regulations that were implemented in 2009 to discourage banks from taking risks that could lead to another financial crisis. Part of the Volcker Rule prohibits banks from engaging in proprietary trading.

It also forbids banks from making certain kinds of investments that are considered too risky, such as those related to hedge funds or private equity funds.

What’s important to understand about this rule is that it does not completely prohibit banks from all forms of trading.

They are still allowed to trade securities for their customers, and they can engage in certain kinds of market-making activities. It's just that they are no longer allowed to use their own money to make trades purely for their own profit.

There are a few different motivations behind the Volcker Rule. Firstly, it’s meant to reduce the chances of another financial crisis. Secondly, it’s meant to level the playing field between small and large banks. Smaller banks don’t have the same kind of deep pockets as larger banks, so they are at a disadvantage when it comes to taking risks.

Who Is Proprietary Trading For?

Proprietary trading is for experienced traders who are comfortable with taking on more risk. It can be a very profitable endeavor, but it is not for everyone. You need to have a solid understanding of the markets and be able to handle the stress of risking more money.

The top proprietary trading firms usually look for traders who have a proven track record. They want to see that you can make money by trading before they give you any capital. This means you must have your own trading account and a good history of profitable trades.

If you’re new to the world of trading, starting out as a prop trader is probably not the best idea. But if you’re an experienced trader looking to take on more risk and potentially earn higher rewards, prop trading may be a good fit for you.

Final Thoughts: Is Proprietary Trading Worth It?

Some people believe that proprietary trading is unfair because it gives an advantage to the firm that is doing the trading. However, if a firm is good at it, proprietary trading can prove very lucrative and subsequently can make a lot of money for its shareholders.

In the end, it is up to each individual investor to decide whether or not they want to invest in a firm that engages in proprietary trading.

If you are willing to take on some risk and are comfortable with being exposed to potential losses, proprietary trading jobs may be a good fit for you. Just be sure to do your research and understand the pros and cons before getting started.


What is a spot trader?


A spot trader is a type of prop trader who buys and sells securities, commodities, or currencies with the intent of holding the position for a short period of time. Spot traders generally don't have a bias towards any particular direction in the market; they simply attempt to take advantage of short-term imbalances in supply and demand.

Because they hold their positions for such a short period of time, spot traders typically don't take into account broad fundamental factors when making their trading decisions. Instead, they focus on things like price momentum and technical indicators.

How much do proprietary traders make?


According to Glassdoor, the estimated proprietary trading salary in the United States is $91,500. This includes the base pay and the additional pay. 

Based on this estimate, the average base pay for a trader in this industry is $73,768, while the average additional pay is $17,732. Additional pay can come in the form of bonuses, tips, commissions, and profit sharing.

Who carries out proprietary trading?


Proprietary trading is typically carried out by major institutions, such as commercial banks and investment firms. However, smaller firms and individual traders can also engage in this type of trading. 

All they need is the capital to finance their positions and access to the necessary trading platforms.

About author

Albert Einstein is said to have identified compound interest as mankind’s greatest invention. That story’s probably apocryphal, but it conveys a deep truth about the power of fiscal policy to change the world along with our daily lives. Civilization became possible only when Sumerians of the Bronze Age invented money. Today, economic issues influence every aspect of daily life. My job at Fortunly is an opportunity to analyze government policies and banking practices, sharing the results of my research in articles that can help you make better, smarter decisions for yourself and your family.

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