Proprietary Trading

Key Takeaways

Many investors tend to think that the bulk of the stock market trading volume is from retail individual investors. However, that couldn’t be farther from the truth. Apart from retail traders, several institutions, firms, and corporates also participate in day-to-day stock market activities.   

In fact, even the stockbroking houses, with which investors have 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 proprietary trading is? Read on to find out the details of this unique concept. 

What is Proprietary Trading?  

Proprietary trading or prop trading is when a financial institution (e.g. a brokerage, investment bank or hedge fund) trades stocks, bonds, or derivatives with its own capital instead of on behalf of a client.  

In a nutshell, the answer to what is proprietary trading is simple: It is when financial institutions trade with their own capital and earn direct profits, not commissions or brokerage fees. This enables companies to utilise market opportunities, hedge positions, and enhance total profitability by making strategic in-house trading decisions.  

How Does Proprietary Trading Work? 

Proprietary trading (prop trading) in regions such as India, the USA, and the UK follows a similar model, in which financial institutions allocate their own capital to selected financial instruments, aiming to profit from price changes. Different firms use varying strategies, including high-frequency trading (HFT), involving rapid, numerous transactions or fundamental analysis focusing on company and economic data.   

Additionally, statistical arbitrage identifies pricing discrepancies across related instruments, while event-driven strategies leverage market shifts caused by events such as mergers, acquisitions, or earnings reports. These tactics are commonly utilised by prop trading firms globally. 

Importance of Proprietary Trading 

Proprietary trading, or "prop trading," is crucial to financial markets for several reasons, but liquidity and market efficiency are among the most important ones. Prop trading firms use the institution's own capital, not client funds, to make direct trades. Since the firms likely have substantial capital, their trading volume is significant, thereby boosting market liquidity. Higher liquidity means assets can be bought and sold quickly without drastically affecting their price, benefiting all market participants, including everyday investors.  

Prop trading desks often focus on highly complex, short-term strategies, arbitrage, and statistical modeling. Their continuous presence and willingness to take on risk help smooth out price discrepancies across different exchanges or assets, ensuring that prices accurately reflect all available information. That’s why proprietary trading is fundamental to market efficiency.  

Furthermore, prop trading is a powerful engine for financial innovation. The high-stakes environment demands the development of cutting-edge trading algorithms, high-speed technology, and advanced risk management systems. These innovations often trickle down, enhancing the infrastructure and security of the broader financial ecosystem. Successful proprietary trading also provides a substantial source of revenue for financial institutions, diversifying their income beyond traditional banking and brokerage fees. This revenue stream supports their overall stability and growth. Finally, by aggressively seeking out profitable opportunities, prop traders help allocate capital to its most productive uses, contributing to overall economic health. 

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 engage in proprietary trading to profit from investing in the stock market. The company would then use the revenue earned from the market 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 utilise a mix of several trading strategies, such as fundamental analysis, technical analysis, and various arbitrage strategies.  

Benefits of Proprietary Trading 

Many financial institutions engage in proprietary trading due to its unique benefits. Let us take a detailed look at the benefits of prop trading:  

The primary goal of proprietary trading is to make a profit for a given financial institution. These big financial institutions usually use their funds and rely on trading strategies, and hence can earn huge profits.   

Every kind of trading needs solid research backed by market data and innovative strategies to make profits. Financial firms can use their knowledge and research to earn huge profits by investing in assets such as gold, stocks and even bonds. Many financial institutions invest heavily in technology and research, which helps them gain market insights. This helps the companies make huge profits and also adds to their existing financial knowledge. 

In prop trading, financial institutions rely heavily on active portfolio management that helps them manage risk efficiently, unlike traditional trading.  

With prop trading, financial institutions can attract top talent from the industry, which is incredibly rewarding in the long run.   

Prop trading helps increase liquidity in financial markets, making it easier for other participants to enter. By providing multiple buying and selling opportunities, prop trading desks help maintain an efficient and orderly market. 

Hedge Fund vs. Prop Trading

Hedge funds and proprietary trading are key components of the financial sector, but they have distinct objectives, structures, and activities: 

Hedge Funds: 

Hedge funds aim to deliver absolute returns, positive returns regardless of market conditions, to their investors (limited partners) through active management of diversified investment portfolios. 

Hedge funds raise capital primarily from institutional investors, high-net-worth individuals, and occasionally from retail investors. 

They implement hedging strategies, employing long and short positions, derivatives, and other financial instruments to manage risks and reduce potential losses. 

Hedge funds invest flexibly across multiple asset classes like equities, bonds, commodities, derivatives, private equity, and real estate. 

They often follow a “2 and 20” model, charging a 2% management fee and a 20% performance fee based on returns.  

Proprietary Trading:

Proprietary trading aims to generate profits for the financial firm using its own funds rather than client capital. 

The firm’s own capital is used for trading activities, without relying on external fundraising. 

Prop trading desks use advanced risk management strategies to maximise gains while limiting losses through active risk control measures. 

The core focus is on trading activities, utilising strategies like market making, arbitrage, and event-driven trades. 

Proprietary trading is governed by regulations that maintain financial stability and control risks associated with these activities. 

Conclusion 

Because financial institutions undertake proprietary trading using their own capital, they have the autonomy to take calculated risks and control profits and losses. This autonomy empowers companies to implement high-level strategies such as arbitrage, hedging, and market-making to achieve maximum returns. Proprietary trading is significant because it can create better liquidity in the market and facilitate efficient price discovery, as well as offer more stability to the depth of financial markets. It also enables the institutions to have a variety of sources to raise revenue from other avenues rather than client-based transactions, and this strengthens the financial stability in the long run.  

Proprietary trading can not only be more profitable than other trading systems, but it can also lead to innovation based on the use of advanced algorithms and analytical systems. This allows firms to recognise the uncommon opportunities present in the marketplace. Moreover, proprietary traders contribute to stabilising market movements by providing constant liquidity. When executed with sound risk management and expertise, proprietary trading serves as a key driver of institutional growth, market efficiency, and sustainable financial performance.