What is Proprietary Trading?

Podcast Duration: 05:19

Welcome to this podcast by Angel One.

Today we are talking about trading- but of a slightly different kind. Like many investors, you may think that the bulk of trading volume on exchanges is composed of individual investors. But that’s actually not true. Many firms, institutions and companies take part in day-to-day stock market activities alongside retail traders.

In fact, even the brokerage houses you have your trading accounts with, are known to regularly trade and invest in the stock market. When financial institutions like broking houses, hedge funds, investment banks or commercial banks participate in stock market activities, it is known as proprietary trading. It is also referred to as ‘prop trading’.

Companies trading- cool, isn’t it?

By the way, the funds they use for trading and investing in the stock markets is the company’s own, not their clients money! So do not worry.

Now, why would these firms and companies want to trade on markets?

Well, financial institutions take part in prop trading purely for corporate self-interest. Financial firms and stock broking houses face tough competition, and they operate with extremely lean margins on their offered products and services. For example, you might have noticed how minimal the fees associated with your Demat account are.

While financial institutions do earn through their products, but often it is not enough to sustain the company on the long run. Which is why they indulge in proprietary trading to make gains by investing in the stock market. The returns earned from market investments would then be used by the company as they require, often for sustaining business, building towards future plans or simply, improving their product.

Financial firms are at a vantage point compared to the average retail individual investor. That is because, first, they trade with significantly more money, allowing them to buy a large number of well-performing shares and consequently earn high returns. Second, by virtue of dealing in financial products, they have vast knowledge repositories and access-to price sensitive information which is not as easily accessible to the regular trader.

Compared to investing in government bonds and term deposits, the stock market can fetch higher rates of return for such institutions.

Now you might wonder, what kind of trading strategies do these firms indulging in proprietary trading use?

While financial firms do trade in equities like a lot of investors, you can say that their main focus remains on derivatives like futures and options. Both are, what we call, forward contracts between the seller and the buyer to purchase or sell an asset at a certain price on a future date. While options trading gives you the option to sell the asset in the future, futures contracts obligate you to do so. Forward contracts are often used by such firms for bulk orders. The spread between the current price of an asset and the agreed-to price creates the window for gains, or unfortunately, for losses.

Companies still indulge in derivative trading like options and futures and the trades made by them are often speculative. Prop traders use a variety of strategies including some that you may have heard about, like technical analysis, fundamental analysis, and arbitrages. They help in making smart speculations.

But what does it mean for the market when these big parties are trading?

The presence of these big players is usually a positive influence on the markets. You see, as they have access to way more investment capital, they can easily make a large number of trades. Either in one asset or across multiple exchanges. What this does is introduce a lot of liquidity, which makes it easier for individual investors to trade in securities.

In a sense, prop trading gives a firm the opportunity to become a ‘market maker’ and be able to influence a market by increasing demand or supply.

Another interesting thing firms do in proprietary trading is ‘stocking up’ shares. Firms purchase shares of companies in their inventory. They can sell their ‘stock’ of shares of a company back to the company itself and make profits from the sale.

In case of losses, the firms bear it themselves as they are using their own capital and not their clients’. But with advanced trading softwares and vast knowledge repositories, they do have the competitive edge over the lone buyer. They use precise algorithms and also make a lot of automated trades through their platforms. This makes them bold players and their presence often makes markets healthier.

If you want to know more about proprietary trading and trading strategies, visit www.angelone.in to tap into the wide range of fun and informative content.

Thanks for tuning in, and as usual, happy investing!