What Is Prop Trading? In Plain English (2024)

Prop trading is getting attention: search volume on the term has nearly tripled in five years. But what is prop trading, and why are people so curious about it? Could you have a future as a prop trader?

Let’s take a closer look.

What Is Prop Trading?

What Is Prop Trading? In Plain English (1)

“Prop trading” is short for “proprietary trading”. This occurs when a financial institution invests in the market directly for its own benefit rather than for the benefit of its clients. In other words, the financial institution will invest using its own money, and instead of receiving a commission or a piece of the profits, it keeps all of the profits.

Now, the assets the firm invests in could be anything; it doesn’t have to be the stock market in particular. It could put its money in commodities, currencies, bonds, or even crypto derivatives. If the firm is investing using its own funds, not its clients’, it is considered prop trading.

In recent years, firms devoted exclusively to prop trading have emerged. That is a consequence of a legal change dating back to the 2008 financial crisis.

📈 Learn more: If you’re new to the world of investing, our latest post offers a comprehensive guide to get you started on the right foot.

What Is Prop Trading: The Origins of Prop Trading Firms

In 2010, the Obama administration enacted the Dodd-Frank Act, also known as the Wall Street Reform and Consumer Protection Act. Part of the Dodd-Frank Act was the Volcker rule, named after Paul Volcker, the former chairman of the Federal Reserve.

The Volcker Rule limits the speculative investments banks and other financial institutions are able to make. The idea is that since banks should serve their customers first, proprietary trading can present a conflict of interest.

As a result of the Volcker Rule, many banks have had to either shut down their proprietary trading operations or separate these operations from the rest of their core operations with what is called a Chinese Wall.

The vacuum created by the Volcker Rule was filled by companies dedicated exclusively to prop trading.

🏦 Learn more: New to banking or just want to understand it better? Check out our comprehensive guide covering its various aspects.

What Is a Prop Trader?

Most of the people searching for information on prop trading are not financial institutions. So why are ordinary Americans so curious about big institutions trading on their own account?

When a financial institution delves into prop trading, it will establish a proprietary trading desk internally, which will usually be segregated, i.e., “roped off,” from any trading desks using clients’ money. This separation ensures that prop trading desks remain autonomous and that client-serving desks always serve the best interests of the clients.

The people working on that proprietary trading desk are called prop traders. Traditionally, these traders have been employees of the company. Lately, some companies have come up with a new strategy: engaging independent traders to trade with the company’s money. The company takes a percentage of all profits earned from the trades.

Trading with someone else’s money sounds like a great deal, and that’s where the interest comes from. But what does it take to be an independent prop trader? Could you do it?

How Independent Prop Traders Work

If you become a prop trader, you will operate as an independent trader in contract with a financial institution/ prop firm, where you agree to trade on their behalf.

Financial institutions don’t just throw money at independent traders and expect profits to come rolling in. If the prop trader isn’t an employee of the financial institution, then they often have to put in part of their own money when trading, called risk contribution.

This ensures that the outside trader not only has the firm’s best interests at heart but is also staying away from anything too risky. Additionally, if the outside trader makes any bad bets, the losses are deducted from their capital first before hitting the firm.

In return, the outside trader agrees to split any profits with the firm in a ratio that is agreed upon beforehand. Since the outside prop trader takes on most of the risk, they usually take the largest share of the profits.

You put up some money, and the firm puts up the rest. You take the bulk of the risk, but if you earn money, the company will take a cut.

What Is Prop Trading: Pros and Cons

In the world of prop trading, there are two main players: prop firms and prop traders. You’re probably not a financial institution, so let’s look at the pros and cons from the trader’s perspective.

The Pros ➕

If you are considering becoming a prop trader, then there are a few positives you can look forward to:

1. Additional Capital

If you have $25,000 and try to become a retail investor, you will be limited in the investments you can make. Combining your capital with money from a financial institution will expand your range considerably.

📈 Learn more: For those seeking an affordable trading experience, our latest post breaks down top discount brokers tailored for retail investors.

2. Leverage

A prop firm may not always enforce leverage limits, particularly if you have a history of success. Using that leverage (borrowed money) effectively can dramatically expand your opportunity for profit.

3. Open Orders

For some traders, open orders are a way of life, enabling them to have their fingers in several pies. So, if this applies to you, then prop trading could be a good option, as several firms will let you have a thousand-plus open orders simultaneously.

4. Increased Opportunities for Diversification

Not only does a prop firm give you some of its capital to invest with, but it also provides leverage and lets you have thousands of open orders at the same time. Consequently, you have the resources to develop a more diversified portfolio, minimizing your exposure to any particular risk.

5. Easier Shorting

Prop firms often have their own internal stockpiles of securities. One of the benefits of that is if you want to short a stock, you can borrow it directly from the prop trading firm and sell it on the market.

6. Choice of Trading Platforms

Prop firms have a technological advantage over the market, and part of that comes in the form of highly sophisticated research and trading tools. And since they want to see you win on their behalf, they are happy to share their tech platforms with you, giving you a leg up over the average retail investor.

7. Excellent Support

Seeing as a prop firm’s success is intertwined with the success of its traders, it should come as no surprise to learn that prop firms provide top-notch support. Not only is the support quick, but most issues are resolved through a phone call.

8. Flexibility

Unlike many jobs in the financial sphere, prop trading can be done remotely and from the comfort of your own home. You get to set your hours and decide how much time you are willing to put into this.

The Cons ➖

Most of the negatives related to prop trading come from the high degree of risk and volatility involved, especially if you treat prop trading as you would day trading. That said, here are some of the biggest drawbacks you want to be aware of:

1. Less Regulation

If a prop firm provides remote trading, chances are it isn’t regulated whatsoever. Now, while no regulation translates to lower operating costs, it also means that you, the prop trader, could lose the money you put in, the risk contribution, especially if the firm in question is comprised of charlatans.

This just goes to show how important it is for you to do your own research when choosing a prop firm to work with. If you see any signs of dishonesty, you should go firm shopping somewhere else.

2. Firms May Charge High fees

Aside from the risk contribution, a prop firm may ask you to pay fees for using their software solutions, particularly if you work from home. These fees start at $200/ month and go up from there.

3. The Leverage You Get is Conditional

Earlier, we talked about how prop firms can offer you leverage and increase your liquidity. However, most of the leverage you get will be for positions that are short-term or even same-day.

If you are looking to hold a position overnight, let alone for the long haul, the prop firm may not be so generous with its credit lines.

4. Your Intellectual Property Will Always Be At Risk

As an investor, one of the most valuable assets you develop over time is your investing strategy. Your strategy becomes your intellectual property. And when you find a profitable investing strategy, you end up with an asset that a prop firm may try to steal. In fact, some firms may try to teach your strategy to AI models and have them emulate you in the market.

5. Prop Trading Can Be Very Competitive

These firms are giving you their money with the expectation of high returns, and you need to deliver if you want to stay in the firm’s good graces. If you fail to live up to their expectations, these firms know that there are hundreds of other traders out there who would love the liquidity and the increased buying power that they offer.

6. Limited Career Options

The skills you develop as a prop trader will probably not come in handy anywhere else. So, if you invest years of your life trying to become one of the best prop traders out there, you are also limiting yourself and shutting other possible career doors.

Prop trading might have its allure, but you need to consider these drawbacks before embarking on this journey. If you have weighed the pros and cons and still feel that this is for you, then let’s see how you can get started.

How to Become a Prop Trader

What Is Prop Trading? In Plain English (2)

If your heart is set on a career in prop trading, here is the best way for you to get started.

  • Assess your qualifications. Prop trading firms are not out there throwing money at anyone who wants to trade. They are looking for individuals who have experience and knowledge of markets and trading techniques. If you have those, you’re good to go. If you don’t, you may have work to do before you can qualify.
  • Learn about the industry. It’s not enough to know what prop trading is. You want to know what skills you need to succeed, how you can best acquire those skills, and how to find the right firm for you to partner with. Fortunately, there are several online resources to help you in that endeavor.
  • Approach the firms that interest you. Once you have a short list of firms, approach them and negotiate. While you will bear the brunt of your losses, the general consensus is that when it comes to splitting profits, prop firms take anywhere between 10-25%, and you take the rest. Where you land exactly with your prop firm wholly relies on your ability to negotiate the best deal for yourself.
  • Have your contribution ready. Assuming that you and the prop firm have arrived at some kind of deal, you need to be ready to deposit your risk contribution with them. If you will be trading remotely, then you also need to be ready to pay a little extra to license the firm’s proprietary trading software.

As you might have noticed, one of the most important steps is to find the right prop firm to work with. What factors should you be choosing when fishing for firms?

Ever wondered about the world of #proprietary-trading? Dive into this detailed guide to get in the know. 📊

Choosing the Right Firm

Start by making sure that the firm in question has a spotless track record and is legitimate. Try scouring the internet for online reviews and talk to other traders who have either worked with the firm or are still working with it. You should also look up the managers over there just to make sure that they haven’t been involved in any scandals before.

Once you’ve done your preliminary due diligence, you should start assessing whether the prop broker will be able to meet your individual needs. Here are some of the features you can look into:

  • Does the firm use a demo or a real account when testing its potential traders? There are plenty of benefits to paper trading, i.e., trading through a dummy account, but succeeding with a real account lets you hit the ground running.
  • What markets does the prop firm invest in? How familiar are you with these markets?
  • What are the firm’s trading hours? Does the firm prefer day trading or. overnight trading?
  • What is the average profit split at the firm?
  • What are the required fees, including the risk contribution and the licensing fees?
  • Does the prop firm provide its traders with any training, online or otherwise?
  • What trading strategies are most used at the firm? Are there any limitations on the strategies that you can use?
  • What options will the firm offer you in terms of capital scaling?
  • Does the firm foster an open community?

The answers to these questions can help guide you toward a prop trading firm that is perfect for you.

The Latest Developments in the World of Prop Trading

After the financial crisis of 2008, the Obama administration enacted the Dodd-Frank Act, also known as the Wall Street Reform and Consumer Protection Act of 2010. Part of the Dodd-Frank Act was the Volcker rule, named after Paul Volcker, the former chairman of the Federal Reserve.

The Volcker Rule limits the speculative investments banks and other financial institutions are able to make. The idea is that since banks should serve their customers first, proprietary trading can present a conflict of interest.

As a result of the Volcker Rule, many banks have had to either shut down their proprietary trading operations or separate these operations from the rest of their core operations with what is called a Chinese Wall.

The vacuum created by the Volcker Rule that several companies dedicated exclusively to prop trading has sprouted up in the past few years.

What Is Prop Trading: Conclusion

For many, prop trading is a viable way to make good money. However, the space is fraught with problems, given how little regulation goes on there. So, if you want to start a career as a prop trader, then you need to be aware of both these positives and the negatives first. In case you are still sure that this is what you want, you should take your time and make sure that the firm you choose to partner with is legitimate and has a solid reputation.

What Is Prop Trading? In Plain English (2024)
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