Proprietary trading, also known as prop trading, involves trading financial instruments using a firm's own capital rather than its clients' money.
Let's take a deeper look at how the proprietary trading process works for both businesses and individual traders.
Prop trading relies on individuals and companies conducting trades in order to generate profits for themselves rather than clients.
Rather than brokers earning commissions by facilitating trades on behalf of customers, proprietary traders put up their own cash and keep any profits they make through their market activity. This model is popular among financial firms and individual traders seeking to profit directly from their trading skills.
How Does the Prop Trading Process Work in Businesses?
Many large financial institutions set up proprietary trading desks that handle billions of dollars in the firm's capital. These trading "prop desks" allow banks and brokerages to profit from successful speculation independent of serving clients.
The proprietary trading process at such companies generally involves:
- Establishing trading strategies based on market analysis by in-house researchers and quants. Popular approaches include high-frequency trading, statistical arbitrage, and macro trading.
- Deploying sizable amounts of the company's money, sometimes tens of billions, across various proprietary trading accounts to implement the strategies on exchanges.
- Using computer algorithms and quantitative models to rapidly enter and exit large volumes of trades according to programmed instructions.
- Strict risk management to closely monitor positions and limit potential losses from adverse market movements.
- Sharing trading profits between the company and individual traders/teams based on performance.
Large-scale prop trading benefits companies by supplementing revenue from commissions and advisory fees. It also enables firms to recapture a portion of their capital's potential gains internally rather than paying out profits to external money managers.
How Can Businesses Make Profit with Proprietary Trading?
There are a few ways businesses can potentially earn high returns through prop trading. First, generating consistent trading profits obviously adds a significant revenue stream.
But successful strategies can also benefit firms in other ways:
- Leveraging large capital pools to execute high-volume trades that individual traders cannot match. Economies of scale improve odds of profitability.
- Recruiting talented quant traders by offering lucrative incentive structures and complex, fast-paced work.
- Accessing ultra-low-cost direct market access that streamlines implementation of quantitative models.
- Developing lucrative proprietary trading algorithms and data analysis tools that can later be licensed to generate recurring fee income.
- Investing trading profits back into the business to expand market influence through new technologies, order flow deals, information systems, and global offices.
So while trading gains provide the primary profits, top firms turn their proprietary trading banking operations into sustainable competitive advantages through scale, talent acquisition, products, and vertical integration. For a well-run prop desk, the returns can be substantial.
What is the Difference Between an Investment Account and a Proprietary Trading Account?
When it comes to using capital for financial gain, there are a few key distinctions between standard investment accounts and proprietary trading accounts:
- Goals - Investment accounts aim to grow wealth long-term through sectors/markets, whereas prop accounts actively seek alpha in the near-term from various strategies.
- Holdings - Investors commonly buy and hold stocks/funds, averaging costs. Traders open and close positions much more frequently based on technical, quantitative, or market factors rather than fundamentals alone.
- Timeframes - Most investors think in terms of years or decades when holding. Traders deal in days, weeks, months—constantly adjusting to changing conditions and profit-taking opportunities with the intent to realize gains more quickly.
- Risk profile - Buying and maintaining investments adheres to a buy-and-hold philosophy that downplays timing risk in exchange for expected market uptrends over the long run. Trading exposes capital to constant intraday/intraweek fluctuations that demand much closer oversight.
- Tax implications - Capital gains for long-term investments benefit from preferential rates (at least in some jurisdictions like the US). Day trading profits get taxed as ordinary income which is usually at a higher percentage without qualitative benefits.
While both involve deploying money into financial vehicles, proprietary trading accounts represent a much more active approach focused on short-term gains extracted from constant analysis, not passive wealth accumulation driven by fundamentals and time in the market.
Precision, control, and nimbleness trump simplicity and set-it-and-forget-it with prop strategies.
What Types of Strategies are Used in Proprietary Trading?
A wide range of approaches can be applied within proprietary trading based on the types of opportunities traders perceive across diverse markets and timeframes. Here are some of the most common:
- Statistical arbitrage (stat arb) - Using sophisticated models and extensive historical stats, traders search for momentary pricing discrepancies between highly correlated instruments to profit off them converging.
- Scalping - A very short-term style focused on tiny gains from frequent intraday positions. Success depends on extreme discipline, trade filtering, and avoiding commissions/slippage.
- Mean reversion - When an asset sharply rises or falls in a short window, it will oscillate back towards its long-term average according to this theory. Trades are opened in the overextended direction.
- News trading - Big macro events, earnings reports, and other catalysts create volatility that news traders aim to capitalize on by establishing positions before announcements hit wires.
- Market making - Providing liquidity by constantly buying and selling near the inside market prices, shaving fractions of a cent off bid/ask spreads on huge volumes. Works best with ultra-short holding periods.
- Fundamental analysis - Traditional approach studying company financials, industry trends, management quality, and more to find longs that stand to appreciate substantially over the mid-term horizon.
The strategies that consistently profit depend greatly on the individual trader's analytical strengths, risk profile, available capital for position sizing, and preferences around time spent actively watching markets. A whole menu of choices exists.
What Types of Financial Instruments are Commonly Traded in Prop Trading?
While literally any tradable asset class can theoretically be incorporated into a proprietary trading strategy, several predominate based on their liquidity, information efficiency, and suitability for various approaches:
- Stocks - Efficient global equities markets with immense volumes provide fertile ground for statistical arbitrage, program trading, and other quantitative tactics. High liquidity makes entries/exits easy.
- Futures - From commodities to indexes to currencies, futures trade virtually 24/7 and attract trend-following, news, and macro strategies due to their sensitivity to macro factors and optionality.
- Forex - As the world's most substantial financial market by trading size, the FX market breathes life into scalable strategies involving currency pairs. Constant activity allows strategies execution.
- Options - Volatility trading, news plays, and other directional styles flourish on options markets, which convey asymmetrical risk/reward through their interactive Greek factors.
- Cryptocurrencies - The fast pace, technology-driven crypto sphere presents both challenges and opportunities for both discretionary and algo-centered prop approaches due to its infancy. As it matures, crypto is likely to see even more proprietary involvement.
Naturally, choice of instrument mix depends heavily on one's capabilities, preferences around market behavior, and the strategies deemed most advantageous given prevailing conditions at any point in time.
A balanced portfolio spreads risks while capturing mispricings across global listed and OTC venues.
In today's digital era, a growing number of businesses are discovering the value of running proprietary trading operations to capitalize on investment opportunities and generate additional revenue streams.
Through leveraging proprietary trading accounts and recruiting expert traders to actively manage portions of the balance sheet, firms can actively cultivate an advantage. Profit-sharing arrangements function as powerful incentives for both the business and individual traders.
For those seeking to break into this field, a viable route is through pioneering digital banks like Jetonbank.
Jetonbank is licensed and authorised by the Financial Services Unit, Ministry of Finance of the Commonwealth of Dominica, licensed as a banking institution under the Offshore Banking Act, fully authorised to provide services to clients worldwide, under the prudential supervision of the Financial Services Unit.
With Jetonbank, you can gain exposure to global financial markets through robust online trading platforms.
