What Is Proprietary Trading?

 

Trade is a fundamental aspect of our lives and this is even more so when you consider just how accessible the larger market is to everyday people. Unsurprisingly, they aren't the only ones participating in trade with brokers, often in the form of more experienced traders, specific platforms, and financial institutions helping them.

 

While financial institutions in particular will help other entities in the issues of trade, they will, without a doubt, go into business to make a profit for themselves, hence proprietary trading. Let’s get a deeper sense of what this style of trading is and how it functions!

 

Contents:

- What this form of trading is

- Types of entities

- How it works

- What comes with it

- Final thoughts

What this form of trading is

Just for a clearer definition, this form of trading entails that larger financial institutions such as investment banks use their resources to fund all trading endeavors. The man by which they do this will naturally involve as many strategies as possible, some of which include the following:

- Multiple forms of arbitrage

- Both fundamental and technical analysis

- Macro trading on a global scale

Types of entities

Entities using this style have great variety in terms of what their interests are. Essentially, nothing is out of the realms of interest which means that they will deal in everything from bonds and stocks to commodities and forex. As for the types of entities you're likely to see participating in this type of trade, they include the following:

- Investment banks

- Brokerages

- Hedge funds

- Other similar institutions

 

Banks were able to participate in this type of trading, but that changed after the 2008 economic rough patch when it was seen that speculative endeavors of the Prop trading kind helped lead to the rough period. Now, measures like the Volcker rule exist specifically to combat that.

 

“Why would they do this?” you may ask. Well, it boils down to whether or not it's more profitable to simply receive commission from a good job, or take all the risk and reap the rewards of a successful trade. Larger institutions typically have no issues going down this path, because not only do they have the capital, they have the general competitive advantage which gives them an edge over other styles.

 

How it works

Interestingly enough, how this particular style of trading functions is rather simple, save for the typical complexities that plague the space. The idea is that participants’ trading desks utilize their balance sheets as well as capital to proceed with transactions, promoting themselves in the process. This tends to lead to trades of the speculative kind, which often come in the form of derivatives or things of a similarly complex nature.

 

Entities partaking in this style of trade aren't going to stop being third-party mediators for clients as they have the means to continue. As such trading desks can't take in both sets of trades, which is why they're kept separate to avoid confusion and remain faithful to clients’ interests as well as their own.

 

What comes with it

Prop trading, as it's also called, brings with it several positive things. As stated earlier, they allow firms to not only build their portfolios and take sole ownership of the risk, but the reward is solely theirs as well. This money is way more than what they would get by acting on behalf of someone else, but they gave that commission in addition to their returns.

 

Another advantage of this trading style is that stockpiling a host of securities is more than possible. This is not only beneficial to clients, who gain said advantage due to the presence of anything speculative, but aids participants in times where there's great difficulty when it comes to buying and selling. Because of this, participants gain quite a bit of influence as they become a source of liquidity for securities, making them market makers.

 

On the flip side of things, however, is the fact that it's still the market, which is always chaotic and nothing will change that. This inherent volatility will eventually affect those practicing stop trading and because they're using their capital, all losses belong to them as well.

 

Final thoughts

It's quite clear that as with all types of trade, prop trading is something that participants would gladly take the risks for, as the potential returns would be great. When coupled with the fact that risk is 100% on the entity, the profits are kept solely by the company, which they like, although any losses would be treated equally. You can also try automated trading systems that offer benefits such as emotion reduction but come with risks, including technical issues and a potential lack of adaptability. Traders need to carefully consider the pros and cons before implementing any type of trading system in their strategies.

 

What the above also shows is that there have been changes made to prop trading. This speaks particularly to the regulations placed on banks, which couldn’t run this type of ship without leading to some sort of catastrophic economic event, thus protecting clients specifically.

 

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