What is Prop Trading?

What is Prop Trading?

What is Prop Trading

Imagine that a financial company or a commercial bank is faced with a choice: what should they earn on, and what will be the source of the company’s profit? Should it be commissions from client trading or trading using their own funds? If the first option is a low-margin way of earning, the second can bring much higher profitability.

Prop trading companies believe they have a competitive advantage or an understanding of certain market inefficiencies that allow them to achieve an annual return exceeding the index (positive alpha).

Proprietary, private, or prop trading is a case where a financial company prefers generating profit directly from market activity rather than earning minimal-margin commissions from client trading. Such a company focuses on trading with its own funds, keeping all profits from transactions rather than just commissions.

A prop trading company, unlike a fund (hedge fund or investment fund), operates with its own capital or the capital of a relatively small number of participants. It uses this capital not for investment activities in a limited set of securities or other financial instruments with subsequent payments of interest/dividends to its investors but to transfer it to the management of the company's most successful traders. In this setup, the company acts both as an investor, increasing the trading capabilities of individual traders, and as a broker, taking on risk management functions as part of its systemic business model.

At the same time, the degree of freedom for a trader, to whom the company provides funds for management, remains relatively high: the trader independently chooses which instruments to invest in, at what frequency, and with what level of profitability. The main requirement for the trader is to be profitable and follow risk management rules, both individual and company-defined.

For the opportunities provided (mainly regarding capital and technical tools, such as analytical platforms and trading terminals), the trader shares a pre-agreed portion of their profit with the prop company.

Classic prop trading involves the trader trading exclusively with the company’s funds and giving it a percentage of the earnings. This percentage can be part of a public offer or an individual agreement with the company.

There are also mixed forms of proprietary trading. For example, a trader may carry out trading activities using the company’s capital, but the financial risks of trading operations remain with the trader. In this case, the trader gains access to significantly larger capital than they personally have, but all losses are covered from their own deposit stored in the company’s account. In such cases, the prop trading company often acts as a broker—setting commission rates, providing technical support, and offering leverage, thus categorizing this type of trading as margin trading. In addition to commissions, there may be other fees (e.g., membership fees) or a percentage of the trader’s profit.

How a Prop Company Works

Trading with proprietary capital requires the company to have significant funds in its account. Additionally, access to professional software, computational capacities to maintain internal infrastructure, an analytics department, a risk management team, and departments for advertising, recruitment, and training of traders are essential.

The structure of a prop company typically includes:

• Prop Traders: Traders who directly execute trades in the stock market. The company often trains them in its strategies, though some traders come with their own. A prop trader trades with the company’s funds and receives a percentage of the profits.
• Analysts: Monitor the market and provide traders with analytical data on companies and general market information.
• Risk Managers: Track compliance with risk management guidelines by prop traders.
• Manager or Head Trader: A highly skilled trader who determines trading strategies and oversees or conducts training.

Prop Trading Strategies and Training

A prop trader can trade either the company’s strategy or their own. Preference is usually given to traders who use the company’s strategies. For this, traders are trained and tested (e.g., on demo accounts) before being entrusted with capital. If a trader wants to use their strategy, it must be approved by the company and proven effective to the lead trader.

Prop companies use various strategies, including:

• Merger arbitrage.
• Index arbitrage.
• Volatility arbitrage.
• Statistical arbitrage.
• Financial analysis of company performance.
• Technical analysis.
• Global macro trading.

How to Enter Prop Trading

• Experienced Traders with Track Records: Demonstrating a trading history.
• Combines: Evaluation programs with specific conditions for traders to meet.
• Trader Contests: Competitions offering managed accounts as prizes.

Prop trading offers mutual benefits: traders gain capital, training, and experience, while companies achieve higher profitability and trading volumes.