What is Proprietary Trading - The Complete Guide

Proprietary trading, or prop trading for short, is a specific type of trading that is associated with banks and other financial institutions. It has been gaining popularity among retail traders who are seeking to get funding from a broker. For that purpose, these brokers, called prop firms, allocate their own capital to traders who receive the funding into their personal accounts. From there on, they are allowed to trade this capital as they see fit. Prop trading can be done in virtually any market that is available out there. This means stocks, currencies (forex), commodities, cryptocurrencies, and various derivatives.

Broadly, prop trading is viewed as a way for individual traders and investors to participate in the market with a heavier involvement than they would otherwise have. At the same time, financial institutions across the globe can get involved in prop trading by investing their own capital directly without using any clients’ money. This beginner’s guide will shed light on what proprietary trading is, how it works, and how you can benefit from it.

What is Proprietary Trading?

Proprietary trading is the trading activity of banks and other financial institutions that uses their own capital, instead of client funds. Investment banks, commercial banks, brokerage firms, and others in finance may decide to use their own money to trade stocks, currencies, gold, oil, digital assets, and anything else. This is called proprietary trading.

Usually, prop trading is done by institutions that have enough cash to trade with their own account. However, some prop trading firms may allocate this capital to traders who trade on behalf of the firm. This is increasingly attractive to individual investors who must pass an evaluation to prove they can trade.

Nevertheless, this type of trading brings many benefits as it allows the institution to retain the full profits it earns. Otherwise, it would only make money from trading commissions and fees. Being present in every market gives these organizations an edge – their ample liquidity allows them to spread risk more evenly. Let’s find out more about the benefits of prop trading.

Benefits of Prop Trading

Benefits of Prop Trading

Proprietary trading is associated with benefits and perks such as the one we mentioned above – retained full profits instead of clipping a fee from user trades. That way, the organization can go into any market and invest money for its own account. Further, prop trading comes with leverage, reliable support, and more advantages. Let’s break it down and see the benefits.

  • Full profits – the financial institution involved in prop trading does not need to share its profits with anyone. It uses its own money to trade for its own account instead of relying on fees from traders.
  • Rich portfolio – organizations that do prop trading usually spread into different markets and asset classes. They own multiple stocks, currencies, commodities, and even crypto.
  • Reliable support – prop trading firms are famous for their reliable customer and technical support. Agents are quick to respond and pay great attention to a good user experience.
  • Access to leverage – similarly to traditional retail brokers, prop firms use leverage. This gives them the ability to magnify their trading results and get better returns when they have winning positions.
  • Liquidity provision – institutional investors have access to ample liquidity thanks to their resources and exposure to different assets and markets.
  • Diversification to reduce risk – prop trading firms can go into various corners of the financial markets and own different stocks, currencies, and even crypto. This allows them to properly diversify their holdings in efforts to reduce risks.
  • Funding of individual investors - the biggest benefit for individual investors is that prop firms can fund retail clients. Traders can reach out to a prop firm and once they pass an evaluation test, they can receive up to $200,000 in real money to use in their trading. More on that below.

Drawbacks of Prop Trading

Prop trading has some downsides including risk of losing money, patchy regulation, and the lack of a trading approach. Let’s dive in and make it easier to understand in order to show what you can expect.

  • Risk of losing money – when an institution trades with its own money, the risk of losing them is relative to the success of their investment. In other words, the firm needs to rely on its own skill in picking investments in order to make money. Otherwise, if it was acting as a market maker, it would make money regardless of the trading results of its clients. It would simply collect fees and profit from commissions. With trading, however, the prop firm needs to be successful in order to make money. If you are using a prop trading firm and trade with its capital, you can actually be at ease. Once you get funded, you won’t need to cover any potential losses. Your initial deposit may even be returned and you will be trading with the firm’s money. To this end, no prop firm should ask you to cover the loss.
  • Patchy regulation – the regulatory framework under which proprietary trading operates is relatively nuanced compared with other firmly regulated areas in finance. Prop trading firms, for that matter, may or may not be licensed and regulated even if they are providing prop trading services. To be on the safe side, make sure that the company you want to do business with is registered, licensed, and regulated. If you want to go with a thinly regulated prop firm, this could have its upside, too. You can use higher leverage and enjoy lower trading fees. You can also check with the customer support what your rights are. Also, get familiarized with the firm’s terms and conditions to make sure every little detail is acknowledged.
  • Lack of trading approach – This one is more on the trader’s end. If you as a trader get funded from a prop firm, you need to have a proper trading strategy that you can rely on. Both in good times and bad times. It is easy to get your head in the clouds when you see that you passed the evaluation phase and are given $200,000 of real money. The markets are wide and full of opportunities. But this may actually be a trap as it may look that you can make money in every market. The outsize funding, on that note, has the potential to sway your thinking and carry you away from rational thought. To avoid this, design a trading approach that will keep you grounded and focused. You may decide to go for day trading, swing trading, or even scalping. Whatever your strategy is, be sure that it is tried and tested with lower amounts of capital. Don’t rush your trades and don’t trade when you don’t see anything that would give you a clear signal to enter the market.

Prop trading doesn’t come without risks or drawbacks. But if you are willing to work through them, you can actually get your trading to a higher level and become a better trader.

How Does a Prop Firm Work?

How Does a Prop Firm Work?

Prop firms are companies that trade with their own capital. They engage with the financial markets using company funds to buy stocks, crypto assets, currencies, commodities, etc. Prop firms also take a step forward by going to individual investors who, once they pass a test, can trade with the firm’s money.

This is done to help both the firm and the trader win money as the profits are split in a certain ratio. It could go as low as 50-50 and as high as 80-20 for the trader. Essentially, proprietary trading companies could go beyond their own boundaries as an entity and hand out capital to proprietary traders, or prop traders.

These prop traders, experienced traders or even beginners, get into an agreement with the firm, practically becoming recruited as traders. It’s similar to how Wall Street firms operate. The difference, however, is that you can be in your living room and trade hundreds of thousands of dollars in the financial markets. Prop trading was previously reserved for heavyweight firms like Wall Street banks and hedge funds. Today, however, high-capital trading is available to the retail investor who can prove they are worthy of being funded.

On that note, a prop firm works by either trading its own capital or employing outside prop traders to trade for it. You can find below what it takes to become a prop trader and increase your buying power.

How to Get Funding from a Prop Firm?

How to Get Funding from a Prop Firm

When you sign up for a trading challenge and pass it, the prop firm gives you the funding you have requested. In more detail, you need to deposit a small amount of money, usually between $200 and $1000, and trade this money in an evaluation process.

The evaluation process is essentially a trading challenge that you need to pass. Many brash traders underestimate the challenge and open big positions, thinking they will succeed. However, in practice, it is not that easy.

To pass the challenge, most prop firms have set a target: reach a 10% profitability in a 30-day period. Then do it a second time. You will likely have a maximum overall loss and a maximum daily loss. Usually, these fall somewhere between 15% and 5%. In other words, your maximum overall drawdown should not exceed 15% during the whole challenge. And your maximum daily drawdown should not exceed 5% on any given day.

Once you get these in order, you stand a chance to pass the challenge and win the big prize. You may request up to $200,000 in real funding and a refund to your deposit. Regardless of your target prize, winning the challenge is mandatory to get the funding. Along the way, you may use any trading strategy you decide. You can go for day trading, swing trading, scalping, or any other way to make money in the financial markets. You can trade the news or dive into technical analysis.

Getting funding from a prop firm is actually easy for those that know how to trade. These are the traders that measure their risk, assess the opportunities, and jump only when they see something of real value. Generally, this would be a trade that has higher probabilities for profit rather than just any trading position.

Once you get funded, you continue to keep some trading rules that have been previously required. Those include maintaining a max daily drawdown and max overall drawdown. The prop firm gives you ample funds to trade on its behalf. It is understandable, then, that it may want to protect its funding.

If you are handed $200,000, you might decide to bet the farm and open a long position with the entire capital at hand. That’s why the prop firm has introduced protections. Having a max daily and overall loss is protection against a significant loss of funds. This also helps you to be more moderate in your approach to the financial markets. You will want to be more careful and to calculate your risks as well as rewards.

How Much Profit Can You Expect?

How Much Profit Can You Expect

Once you get funding from a prop firm, you can start trading. But know that profits will not just start falling into your account. You will have as much as $200,000 in real money, your deposit returned, and inexhaustible opportunities for profit.

However, that does not mean you should dive into the first opportunity you see. Quite the opposite. Analyze the market carefully and make sure you will not fall prey to your emotions. After careful analysis, invest a moderate amount of capital into a position and be sure to use stop loss order to protect your account.

A stop loss order is an order that will close your position if the price reaches the level you have set in the order. This is a highly reliable way to protect your funds. Knowing that your firm will terminate your agreement if your funds fall about 15% or more during the entire time will keep you on your toes. Moreover, a daily drawdown of around 5% will also have you waving your account goodbye.

In that context, set your expectations according to the rules you will need to follow. Once you do, factor in the leverage. Having access to leverage that goes 1:100 will significantly magnify your profits. But it will do the same to your losses, too. The lesson here – don’t take oversize positions that may turn against you and hit the daily or overall drawdown limit.

After all is taken care of, you should start setting your gaze on the profits. Realistically, you can expect profits that match the level of your investment and the result of your trade. If you open a position with $1,000 dollars and use leverage of 1:100, you control $100,000 in a single position.

That means that for every pip movement, your position, let’s say you bought EURUSD, will either move up or down with around 10EUR. In other words, 100 pips will be 1,000EUR, or $1,000 if they trade at parity.

If you have a $200,000 account, a $1,000 profit will be 0.5% of your total equity. If you double the investment, you will have $2,000 in the same trade. If you scale your investment 10 times you will have a profit of $10,000 in a movement of just 100 pips. These movements happen almost every day across currency markets.

However, if you get it wrong and the trade turns against you in one day, you will be down 5%, or $10,000, on your $200,000 account. That means that some prop firms will close your account since you violated the 5% daily drawdown rule.

To this end, large accounts bring with them opportunities for outsized profits. But they also carry the risk of seeing your account closed if you do not manage your risk exposure properly. Make sure to keep in mind loss limits and profits targets, profit share, and trading periods.

How to Choose a Prop Firm?

How to Choose a Prop Firm

Choosing a prop firm comes down to your own preferences and trading style. If you are a more active trader that seeks the thrill of the markets, you will opt for a prop firm that offers higher leverage. On the other hand, if you approach the markets in a passive way and don’t take too much risk, lower leverage will work better for you.

Proprietary trading firms differ in their offerings, trading platforms, customer support, and overall experience. Make sure to research the market well, weigh competitors, ask around, and finally make your choice.

Conclusion

With all the above said, prop trading firms are quickly gaining traction among the retail trading community. You don’t need to have a degree and pay thousands of dollars to go on Wall Street. Instead, you can simply sign up for an evaluation and prove you deserve the funding. Once you do, the prop firm will move capital to your account that will be all yours to trade.

Keep in mind that it requires trading skills, patience, risk management, and sharp wit in order to both win the challenge and to grow your trading account. If you do it well, you will be in for a fruitful and profitable career with a boastful track record, diversified portfolio with lots of financial instruments, all of this thanks to the firm’s capital which allows you to experience the thrills as a professional trader.

FAQs on Proprietary trading

What is Proprietary Trading?
Proprietary trading is the trading activity of banks and other financial institutions that uses their own capital, instead of client funds. Investment banks, commercial banks, brokerage firms, and others in finance may decide to use their own money to trade stocks, currencies, gold, oil, digital assets, and anything else. This is called proprietary trading. Usually, prop trading is done by institutions that have enough cash to trade with their own account. However, some prop trading firms may allocate this capital to traders who trade on behalf of the firm. This is increasingly attractive to individual investors who must pass an evaluation to prove they can trade.
How does a prop firm work?
Prop firms are companies that trade with their own capital. They engage with the financial markets using company funds to buy stocks, crypto assets, currencies, commodities, etc. Prop firms also take a step forward by going to individual investors who, once they pass a test, can trade with the firm’s money. This is done to help both the firm and the trader win money as the profits are split in a certain ratio. It could go as low as 50-50 and as high as 80-20 for the trader. Essentially, proprietary trading companies could go beyond their own boundaries as an entity and hand out capital to prop traders.
How Much Profit Can You Expect?
Realistically, you can expect profits that match the level of your investment and the result of your trade. If you open a position with $1,000 dollars and use leverage of 1:100, you control $100,000 in a single position. That means that for every pip movement, your position, let’s say you bought EURUSD, will either move up or down with around 10EUR. In other words, 100 pips will be 1,000EUR, or $1,000 if they trade at parity. If you have a $200,000 account, a $1,000 profit will be 0.5% of your total equity. If you double the investment, you will have $2,000 in the same trade. If you scale your investment 10 times you will have a profit of $10,000 in a movement of just 100 pips. These movements happen almost every day across currency markets.
How to Choose a Prop Firm?
Choosing a prop firm comes down to your own preferences and trading style. If you are a more active trader that seeks the thrill of the markets, you will opt for a prop firm that offers higher leverage. On the other hand, if you approach the markets in a passive way and don’t take too much risk, lower leverage will work better for you. Prop firms differ in their offerings, trading platforms, customer support, and overall experience. Make sure to research the market well, weigh competitors, ask around, and finally make your choice.
How to get funding from a prop firm?
When you sign up for a trading challenge and pass it, the prop firm gives you the funding you have requested. In more detail, you need to deposit a small amount of money, usually between $200 and $1000, and trade this money in an evaluation process. The evaluation process is essentially a trading challenge that you need to pass. Many brash traders underestimate the challenge and open big positions, thinking they will succeed. However, in practice, it is not that easy. To pass the challenge, most prop firms have set a target: reach a 10% profitability in a 30-day period. Then do it a second time. You will likely have a maximum overall loss and a maximum daily loss. Usually, these fall somewhere between 15% and 5%. In other words, your maximum overall drawdown should not exceed 15% during the whole challenge. And your maximum daily drawdown should not exceed 5% on any given day.

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George Milios

Lead Generation & Business Growth Specialist

Helping Companies Scale their Organic Traffic & Conversions over the long-term by implementing strategies that work. In addition, George is an avid cryptocurrency researcher, advisor, investor, and trader.

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