Are you wondering what makes prop trading more attractive than traditional trading? In this guide, find out why you can benefit from proprietary trading.
The rise of prop trading has become a significant development in the trading industry, and it’s attracting many young traders. Proprietary trading is known for being dynamic and lucrative, especially as firms eliminate investor risk. With prop trading, firms use their own capital for trading, while traditional trading firms have to manage and safeguard their client’s capital. Prop trading today comes with diverse advantages for the trader and has become a more attractive investment option than standard trading. Join us as we find out how prop trading differs from traditional trading.
What is Proprietary Trading?
Proprietary trading, also called prop trading, happens when a financial institution, investment bank, brokerage firm, hedge fund, or any other trading institution uses its own capital to carry out investments. Rather than using the client’s money, the institution uses its money to trade financial instruments. Then, they can sell the financial instruments to clients for a profit.
The goal of prop trading is to make a profit for the firm instead of trading for the client and then using this to earn commissions. Prop trading firms can invest in different financial instruments like stocks, bonds, currencies, options, futures, commodities, and contracts for differences (CFDs). Nowadays, there are online prop firms, like the OANDA Prop Trader, making it easier to engage in this form of trading.
Prop traders make their income from the profits they generate in the financial market after selling the financial instruments to the clients. This form of trading offers different benefits for both the trader and the clients of the firm.
Advantages of Engaging in Prop Trading
Advantages of proprietary trading differ for individual traders and financial institutions. As a client of a prop trading firm, you can make higher profits without having to choose a financial instrument to invest in. The prop trading firm provides financial securities for sale, allowing traders to make a profit. What’s more, it reduces the financial risk for traders.
Investors can also benefit from learning from other talented traders and professionals. Since prop trading firms usually provide access to advanced technology, investors enjoy the best quality instruments.
Meanwhile, financial institutions or commercial banks enjoy different benefits by engaging in prop trading. They can earn revenues in the form of fees and commissions. This is also a good way for these institutions to stockpile different financial securities. So, if the market is down and it becomes harder to purchase securities, they already have enough to sell to clients.
Prop trading allows financial institutions to become more influential in the market as they provide liquidity on a specific instrument or a group of instruments. However, there are some risks for the prop trading firm, too, as they have to bear all the losses if the purchased financial instrument does not make a profit. Prop trading firms depend on skilled traders, and a lack of traders will affect profitability.
Differences Between Prop Trading and Traditional Trading
There are different ways prop trading and traditional trading differ, whether it’s in the participants or the use of capital.
Participants
Proprietary trading is conducted by financial firms, which include trading firms, investment banks, hedge funds, and other institutions. They use their own capital to trade in financial markets. Meanwhile, traditional trading is typically done by individual investors to make a profit for themselves or brokers who want to trade on behalf of their clients.
Source of Capital
Prop traders get their trading capital from the firm, so if there is a profit, it would be good for the firm. On the other hand, if there is a loss, it would negatively impact the firm’s finances. However, as an individual investor, your capital comes from your personal funds, whether it’s your savings or income. Brokers or portfolio managers get their capital from their clients.
Risk Tolerance
It’s essential to consider risk before making an investment. Prop trading comes with a higher risk because firms take a bigger position and use leverage as they invest in financial instruments. Prop traders also deploy advanced strategies to gain returns. The risk for an individual investor is way less than that of prop trading, especially for managed accounts, since brokers focus on safeguarding client capital.
Trading Strategies
Prop trading firms usually use sophisticated strategies like high-frequency trading (HFT), market-making, arbitrage, and algorithmic trading strategies. They make use of speed, volume, and proprietary technology, and since they have enough resources, they can use state-of-the-art trading platforms and quantitative models.
On the other hand, traditional traders usually make use of strategies like value investing, day trading, and growth investing. They make use of fundamental and technical analysis to make short- and long-term trades. Retail traders might not have access to the best technology and mostly use standard brokerage platforms. Professional brokers might have advanced tools, but not as cutting-edge as prop traders.
Why Prop Trading is a More Attractive Investment Option
Many people are leaning towards proprietary trading today. Buying services or joining a prop firm offers distinct advantages, especially for those who want reduced personal financial risk. Here are five benefits that prop trading offers over traditional trading.
1. Edge
One of the main reasons prop trading is more attractive is because firms have the best financial technologies. All prop traders are equipped with sophisticated trading tools and algorithms, allowing them to make better decisions and enjoy flexible platforms while the clients know that they’re getting the best financial instruments.
2. High Earning Potential
Prop trading comes with a higher earning potential than traditional investing structures. Prop traders usually employ leverage to increase returns, allowing them to take on large positions and capitalize on small market movements. This can offer benefits to the clients, especially since prop traders can use sophisticated strategies. Prop traders can take higher risks since they’re using the firm’s capital, allowing them to take advantage of opportunities that traditional traders might avoid, leading to high profits for clients.
3. Diversified Opportunities
With prop trading, investors can access different types of asset classes, including stocks, bonds, forex, derivatives, commodities, and cryptocurrencies. This offers diversified exposure, increasing opportunities, and gaining profit. Some prop trading firms work with markets from around the world, allowing traders to invest across time zones and use global arbitrage opportunities.
4. Shared Risk
One of the best parts of being a client of a prop trading firm is the shared risk. Prop traders use the firm’s capital rather than their own or that of the client. All the client has to do is purchase financial instruments from the firm, as all the losses are absorbed by the firm. Meanwhile, traders who work at prop firms can earn a percentage of the profits they generate from selling these instruments to clients, all without risking their personal assets.
5. Reduced Costs
Prop firms usually trade in large volumes, which means they get better commission rates, spreads, and fees. All of these allow traders to save costs compared to retail investors. If you want to set up an investment infrastructure like this as a retail trader, it would be really expensive.
Use Prop Trading to Expand Your Portfolio
Prop trading offers a range of benefits, making it an attractive option for financial firms and individual traders. There’s a lot of potential for high profits, greater control over your investment activities, advanced technology, better risk management, and more when engaging in prop trading. But it’s important to remember the risks and combine skill, experience, and top-notch risk management to make prop trading rewarding.
