Many investors tend to think that the bulk of the stock market trading volume is from the retail individual investors. However, that couldn’t be farther from the truth. Apart from retail traders, there are also several institutions, firms, and corporates participating in the day-to-day stock market activities.
In fact, even the stockbroking houses with whom investors possess trading accounts tend to trade and invest in the stock market regularly. This phenomenon is what is referred to as proprietary trading. Want to know more about what is proprietary trading? Read on to find out the details of this unique concept.
What is proprietary trading?
When a financial services firm such as a broking house, an investment bank, a hedge fund, or even a commercial bank engages in trading and investing activities in the stock market, the activity is known as proprietary trading. Stock market pundits also informally refer to this kind of activity as ‘prop trading’. Before you think otherwise, the funds that these firms use for trading or investing in the stock market are their own and not those of their clients.
Now that we’ve answered the question ‘what is proprietary trading?’, let’s direct our focus towards understanding why such firms and institutions engage in such trading activities.
Why do financial institutions engage in proprietary trading?
The answer to this question is quite simple. Financial institutions take part in prop trading purely for corporate self-interest. Due to the stiff competition faced by financial firms and stockbroking houses, they operate on razor-thin margins on their products and services. The revenue generated from their primary business activities may not be enough to sustain them in the long run. And so, they indulge in proprietary trading to profit from trading and investing in the stock market. The revenue earned from the market would then be used by the company to sustain its business and further its objectives and goals.
Secondly, firms and corporations in the financial domain generally tend to have a better competitive advantage over the retail investor segment. They not only possess significantly larger amounts of investment capital, but also have better and faster access to high-level, price-sensitive information, which they can use to their advantage. Proprietary trading allows financial institutions to enjoy a higher rate of return when compared to investing in other options like bonds and term deposits.
What segments do firms indulging in proprietary trading focus on?
While financial firms do get involved in the equities segment, their main focus is on derivatives such as futures and options. One of the primary reasons for such increased trading activity on futures and options is the fact that the trades that these firms make are almost always purely speculative. Proprietary traders utilize a mix of several trading strategies such as fundamental analysis, technical analysis, and various arbitrages.
Does proprietary trading have any other benefits?
Technically, the presence of proprietary traders in the market sort of acts as an advantage for the market participants. Since they’re backed by a large investment capital fund, they’re easily capable of making large trades. This infuses large amounts of liquidity in the counter, making it easier for investors to buy and sell securities. Additionally, prop trading allows the trading firm to become a market maker, giving it a certain degree of influence over the markets.
Another major benefit that proprietary trading has is that it enables the firms to stock up the shares of the companies as inventory. The firms can then sell the stocked up shares to their own clients who wish to purchase them, making a profit in the process.
Since the firms use their own funds for prop trading, they can take on a higher level of risk as they’re not answerable to their clients. Every single profit or loss that they make has to be borne solely by the entity itself. That said, prop trading firms use complex and advanced trading software that is not available for public use. In addition to this, they also make use of algorithmic and automated trading platforms as well for high-frequency trading. This gives them a clear edge over regular retail traders and investors.