What Is Prop Trading?

Jeremy BiberdorfBy: Jeremy Biberdorf

July 2, 2023July 2, 2023

If you’re new to the world of finance, the term ‘proprietary trading’ may seem complex and perhaps a little daunting. However, understanding the basics can help demystify this financial practice.

In the simplest terms, proprietary trading, often shortened to ‘prop trading’, is when a bank or a financial institution trades stocks, bonds, currencies, commodities, or other financial instruments using its own money, instead of its clients’. The primary goal here is to make a direct profit from these trades, rather than earning through commissions and fees from client-based trading activities.

It’s important to note that prop trading is typically carried out by a dedicated group of traders within the institution, who are separate from those handling client transactions. This ensures that the firm’s interests and those of its clients do not conflict.

The world of prop trading isn’t just restricted to big financial institutions. Thanks to the advent of prop trading firms, individuals can now showcase their trading skills, with successful ones getting the opportunity to trade using the firm’s capital and share in the profits. This opens a doorway for budding traders to step into the world of prop trading without risking their personal capital.

Unraveling Proprietary Trading

Commonly known as ‘prop trading,’ proprietary trading is a financial strategy in which banks, investment firms or proprietary trading firms use their own funds to make market trades. The main objective here is to make a direct profit from the market, rather than earning income from commissions gathered through trading on behalf of their clients.

Proprietary trading is not limited to any specific type of investment. It encompasses a wide array of financial markets, from stocks and bonds to currencies and commodities. The underpinning belief behind this strategy is the firm’s confidence in its competitive advantage, which they believe will help them generate returns that surpass those from other investment strategies, like index investing or bond yield appreciation.

What is Prop Trading?

At the heart of prop trading is a dedicated team or desk within the financial institution. This team operates independently from the client-based trading desks to avoid conflicts of interest. The experienced traders here use the firm’s capital and balance sheet to carry out transactions that could potentially boost the firm’s profits. These transactions can vary from being relatively straightforward to highly complex, often involving a range of derivatives or other sophisticated investment vehicles.

To an outsider, these activities might resemble high-risk gambling. However, for the institutions involved, these actions are considered calculated risks based on their perceived advantage over the market. This belief in their competitive advantage stems from a combination of factors, including their deep expertise, advanced technology, and sophisticated market analysis. These elements together form the backbone of successful proprietary trading.

What are the Benefits?

Proprietary trading, despite its complexities and risks, holds a certain allure for financial institutions. This appeal can be attributed to several enticing benefits that this strategy offers. Here’s a closer look at them:

1. Enhanced Profit Potential:

The core benefit of proprietary trading lies in its potential for yielding higher profits. Unlike client trading, where a financial institution’s earnings are primarily restricted to service fees and commissions, proprietary trading provides an opportunity to pocket all profits generated. This direct market gain often overshadows the relatively modest income derived from commissions.

2. Inventory Accumulation:

Proprietary trading facilitates financial institutions to amass an array of securities in their inventory. This stockpile serves a dual purpose. Firstly, it allows the firm to offer unique advantages to their clients, thereby enhancing their service value. Secondly, it equips the firm to better navigate bearish or illiquid market conditions, when buying or selling securities can be challenging.

3. Market Influence:

One of the key advantages of proprietary trading is the potential for a financial institution to act as a market maker. By providing liquidity for specific securities, they can influence market movements, thereby increasing their control over their investments and amplifying their profit potential.

Despite the significant risks and the requirement for specialized resources and knowledge, proprietary trading’s potential benefits make it an attractive strategy for financial firms. The prospect of increased profits, a robust securities inventory, and market influence can significantly reward institutions adept at navigating this complex strategy.

Prop Trading Firms

In recent years, there has been an exciting development in the proprietary trading world. Several prop trading firms now offer evaluation programs for traders aspiring to become funded prop traders, effectively sharing the firm’s capital and splitting profits. This innovative model allows traders to showcase their abilities, with the successful ones earning the opportunity to trade with the firm’s money while sharing in the profits. Click here for a list of the top prop trading firms.

A few of these prominent firms are worth mentioning:

    • FTMO: With a rigorous evaluation process, FTMO ensures that only the most skilled traders have access to its capital. They also provide traders with an excellent educational platform to improve their trading skills. More details about FTMO can be found in this review.

Learn More

    • TopstepTrader: Known for its emphasis on risk management, TopstepTrader funds successful traders in futures and forex. They have a structured evaluation program designed to identify traders who can consistently profit while managing risk effectively. For an in-depth look at TopstepTrader, check this review.

Learn More

The Funded Trader
    • The Funded Trader: This prop firm allows traders to trade forex, commodities, indices, and stocks once they pass the evaluation. It offers multiple account sizes and higher profit splits for successful traders. Here is a comprehensive review of The Funded Trader.

Learn More

Elite Trader Funding
    • Elite Trader Funding: Known for its competitive profit splits, Elite Trader Funding provides an opportunity for experienced and beginner traders alike to trade forex without risking their own capital. Learn more about Elite Trader Funding in this review.

Learn More

These firms have opened a new avenue in the world of proprietary trading, making it accessible for individual traders to prove their abilities and get funded without risking their own capital. The model’s beauty lies in the win-win scenario it offers: the firms get successful traders to grow their capital, and the traders get to trade with significant capital while learning from the best in the business. Check out our article on how to become a prop trader for more insight.

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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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