How Do Prop Firms Work?


Jeremy BiberdorfBy: Jeremy Biberdorf

July 3, 2023July 3, 2023

Proprietary trading firms, often simply called prop firm (prop shops), are like an adventurous group of explorers. They set out into the vast, sometimes unpredictable landscape of the financial markets armed with their capital, trading strategies, and financial acumen. Their sole mission? To identify opportunities for profit. They are adventurers, yes, but ones who take calculated risks.

At their core, proprietary trading firms use their own money to trade assets like stocks, bonds, commodities, or other financial instruments, aiming to profit from buying low and selling high or from other trading strategies. Unlike traditional investment firms or hedge funds, they don’t handle the money of external clients. They operate with their own capital, hence the term “proprietary,” which means ‘owned by the proprietor.’

Think of it as a restaurant where the owner is the chef, investing in the ingredients and putting in the hard work to cook up the meals, which, in this case, are profitable trades. If the meals are enjoyed (or if the trades are successful), the chef gets to keep the profits. The risk? If the ingredients go bad or the recipe fails, the loss comes out of their own pocket.

Some key players in this field include big names such as Jane Street, Citadel Securities, and Optiver. These firms hold a significant place in the financial market. They add liquidity to the market, ensuring smooth trading operations. For example, when you want to buy a stock, there needs to be a seller on the other side, and prop shops often step in to fill that role, making the process faster and smoother. They also contribute to efficient price discovery – that is, they help ensure the prices of traded assets reflect their true value.

In essence, prop trading firms are significant players in the world of finance, and their operations can impact market dynamics. Just like seasoned explorers, they brave the financial wilderness, charting the course for their own journey while also shaping the landscape of the market.

Prop Firms Business Model

Imagine a group of friends who are very good at poker and have amassed a sizable amount of money. Instead of betting their money on individual games, they decide to create a pool of funds. They use this pool to enter various poker games and tournaments, sharing profits and losses. That’s quite similar to how proprietary trading firms work. They pool their capital and use it to trade on different financial markets, aiming to make profits.

The trading happens across a range of financial instruments, such as equities, commodities, currencies, or derivatives, based on the firms’ expertise and the market conditions. These firms employ highly skilled traders who are equipped with sophisticated technology, algorithms, and high-speed networks to make informed trading decisions quickly.

Now, let’s contrast them with hedge funds and investment banks. Hedge funds pool money from external investors and use a variety of strategies to generate high returns. Unlike prop firms, they operate with their clients’ money and owe them a fiduciary duty. Investment banks, on the other hand, provide financial services to corporations, governments, or high-net-worth individuals, including underwriting new debt and equity securities, facilitating M&A, and offering advisory services.

A significant difference between proprietary trading firms and the other two is the risk-reward scenario. Prop firms, using their own capital, shoulder the full risk of their trades. If their trades go awry, they absorb all the losses. However, if the trades are successful, they also enjoy all the profits without having to share them with external clients.

Let’s bring in a real-world scenario to illustrate this. Suppose a proprietary trading firm anticipates that the price of a specific commodity – let’s say oil – is going to rise due to geopolitical tensions. The firm purchases a large amount of oil futures, betting on this price rise. If their prediction is correct and the price of oil goes up, they stand to make a considerable profit by selling these futures at a higher price. But if they’re wrong and the price drops, they face significant losses.

This is why proprietary trading can be quite risky but also potentially highly rewarding. It requires a deep understanding of the market, solid trading strategies, and a high tolerance for risk. The bottom line? Prop firms play a high-stakes game with their own money, navigating the complex and sometimes unpredictable world of financial markets.

Roles within Prop Trading Firms

Prop trading firms, or prop shops as they’re often called, are like well-oiled machines with various parts working together. Each part, or role, serves a unique purpose. Let’s look at some of the key roles within a prop firm: traders, risk managers, and analysts.

1. Traders

The traders in a prop firm are the machine’s pistons. They are the ones who execute trades, acting on the strategies developed by the firm. Traders need to have a deep understanding of financial markets and quick decision-making skills, as they often need to react swiftly to changes in market conditions.

Their performance is typically measured by the profitability of the trades they execute. They’re often rewarded with a percentage of the profits they generate, motivating them to continually strive for successful trades. Click here to learn more about becoming a prop trader.

2. Risk Managers

Risk managers act as the machine’s safety valves. They monitor and manage the firm’s exposure to risk. This includes keeping an eye on market volatility, tracking the firm’s positions across different assets, and setting limits on how much a trader can trade. Their role is crucial to prevent losses from going out of hand.

Risk managers are generally evaluated based on how well they manage to keep the firm’s losses within acceptable limits. Their role might not directly generate profits, but by minimizing losses, they play a significant part in the firm’s financial health.

3. Analysts

Analysts are like the firm’s radar system. They scrutinize market trends, economic indicators, and other relevant data to forecast future market movements. This information is used to develop trading strategies. Analysts need to have strong research skills and a good understanding of macro and microeconomic concepts.

Their performance is typically measured by the accuracy of their forecasts and the profitability of the trading strategies derived from their analysis. They are often rewarded based on the overall performance of the firm, with bonuses tied to successful strategies they helped develop.

In essence, each role within a proprietary trading firm plays a critical part in its operation. Like a well-coordinated machine, the firm’s success relies on these roles functioning together harmoniously, each contributing to the firm’s ultimate goal of generating profits from trading.

Trading Strategies Used by Proprietary Trading Firms

Proprietary trading firms, often known as prop shops, employ a variety of trading strategies to navigate the financial markets. Here’s an easy-to-understand overview of some key strategies: arbitrage, swing trading, and algorithmic trading.

1. Arbitrage

Imagine you’re at a flea market, and you spot a vintage lamp selling for $50. You know that the same lamp is selling for $100 at a store across town. Buying the lamp at the flea market and selling it at the store would net you a $50 profit. That’s essentially what arbitrage is.

In the financial markets, arbitrage involves capitalizing on price discrepancies of a particular asset (like a stock or currency) across different markets. An arbitrageur, or trader, buys the asset at a lower price in one market and simultaneously sells it at a higher price in another market, making a profit from the price difference.

Arbitrage is attractive because it’s considered a low-risk strategy. However, these opportunities are often fleeting and require sophisticated technology to spot and act upon quickly.

2. Swing Trading

Swing trading is like riding the waves on a beach. It involves catching price swings (or changes) in the market to make a profit.

Swing traders hold onto a financial instrument, such as a stock or a futures contract, for a period ranging from a couple of days to several weeks. They aim to capture a chunk of a potential price move. The choice of this strategy depends on the trader’s anticipation of market trends and their tolerance for holding positions over longer periods.

While swing trading can be more profitable than day trading, it also involves more risk as the trader is exposed to overnight and weekend market fluctuations.

3. Algorithmic Trading

Think of algorithmic trading as using a GPS to navigate the financial markets. Traders use algorithms (or sets of predefined rules) to execute trades at speeds and frequencies that a human trader could not achieve.

The algorithms are designed based on certain parameters like price, timing, and volume. Once the market conditions match these parameters, the algorithm automatically executes the trade. This strategy is often used in high-frequency trading, where firms trade large volumes of stocks multiple times in a day.

Algorithmic trading minimizes the impact of human emotions on trading decisions and allows for rapid execution of trades. However, it requires a deep understanding of both trading and programming.

Each trading strategy has its advantages and risks, and prop shops often use a combination of these strategies based on their risk tolerance, market expertise, and the financial instruments they trade in. The ultimate aim, of course, is to turn a profit from their trading activities.

Exploring Various Proprietary Trading Firms

The world of proprietary trading is diverse, with many firms each offering unique opportunities and trading conditions. Here are brief introductions to a few noteworthy firms:

    TopstepTrader
  • TopstepTrader is a proprietary trading firm that operates differently than most. It provides a platform where traders can earn a funded trading account without risking their own capital. Traders demonstrate their skills in a Trading Combine, a real-time simulated trading evaluation, and if successful, they get to trade with TopstepTrader’s capital.
    Elite Trader Funding
  • Elite Trader Funding is another firm offering funded accounts to traders, but with a focus on forex trading. Their model allows traders to keep a significant portion of their trading profits, which can be an attractive proposition for successful forex traders.
    True Forex Funds
  • True Forex Funds is a proprietary trading firm that provides funding to forex traders. They offer multiple account sizes to suit different trading styles and provide traders with a fair share of the profits.
    FTMO
  • FTMO is a well-regarded proprietary trading firm based in the Czech Republic. They offer a unique evaluation process known as the Challenge, where traders demonstrate their ability to manage risk and generate profits. Successful traders are then given a funded account to trade forex and CFDs.

Each of these firms has a different approach to proprietary trading, reflecting the diverse opportunities within this field. Do consider checking out their detailed reviews to get a better understanding of their operations. Or click here for a list of all the top prop trading firms.

The Impact and Controversies Surrounding Proprietary Trading Firms

Proprietary trading firms, or prop shops, serve an important role in the financial ecosystem. They contribute to the liquidity of the market, helping to ensure that when individuals or institutions want to buy or sell assets, there is always a counterparty available. This keeps the market running smoothly and efficiently.

Additionally, by exploiting price discrepancies and betting on price changes, prop shops play a role in efficient price discovery. They help ensure that asset prices accurately reflect their true value based on current information, contributing to the overall transparency and fairness of the market.

However, these firms have not been without controversy. Some critics argue that prop shops can amplify volatility in the market. For example, high-frequency trading (HFT), often employed by these firms, has been blamed for causing ‘flash crashes.’ A notable instance is the Flash Crash of May 6, 2010, when the U.S. stock market plunged and then quickly recovered within minutes, leading to significant instability.

Furthermore, concerns about predatory trading practices, where some traders use sophisticated technology to gain an unfair advantage, have also been raised. This has led to discussions about market fairness and the potential need for additional regulation.

In response to these concerns, regulatory bodies have imposed rules and regulations on prop shops. For example, the Volcker Rule, part of the U.S. Dodd-Frank Act, restricts commercial banks from engaging in proprietary trading. This is to prevent banks from taking on excessive risk and to protect the financial system as a whole.

Other measures include imposing risk controls and surveillance standards to detect and prevent manipulative practices like spoofing or layering. These regulations aim to ensure that prop shops operate fairly and responsibly, without jeopardizing the integrity of the financial markets.

While proprietary trading firms play a significant role in financial markets and can yield substantial profits, they also come with certain controversies and risks. As such, they operate under regulatory oversight designed to maintain market integrity and protect the broader financial system.

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Jeremy Biberdorf
Jeremy Biberdorf

About the Author:

Jeremy Biberdorf is the founder of Modest Money. He's a father of 2 beautiful girls, a dog owner, a long-time online entrepreneur and an investing enthusiast.

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