What is Proprietary Trading and How Does It Work?

What is Proprietary Trading and How Does It Work?

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Unlike a hedge fund, which uses investors’ capital and trades on behalf of clients, and contrary to a Retail Trader who uses their own capital, Proprietary Trading or ‘Prop Trading’ involves trading under a company (a Proprietary Trading Firm) and trading its capital.

Consequently, traders at a Proprietary Firm – ‘Prop Traders’ or ‘Funded Traders’ – directly engage in the financial markets using the Prop Firm’s capital with the objective of generating a return greater than what would be achieved if fully invested in an index fund, for example.

How Does Prop Trading Work?

Most Prop Firms allow Prop Traders to use ‘Risk Capital’ to achieve a return, which is then divided between them based on a predefined agreement. It is important to understand that a Prop Firm generates revenue primarily from the profits of its traders.

While there will be times when a Prop Trader earns a salary for trading, this is rare. Most Prop Traders work on a commission-based system: the greater the return using Risk Capital provided by the Prop Firm, the more the Prop Trader earns. Although this will vary between Prop Traders and Prop Firms, it is generally the case that most Firms work on a 70/30 basis: 70% of the gains are retained by the Prop Trader, while 30% remains with the Prop Firm.

How Does One Become a Prop Trader?

Nowadays, Prop Firms seek talented traders to join their ranks through interviews or challenges given the availability of new technology.  Prop Firms search for traders who achieve consistent returns, observe strict risk-management strategies, and show the ability to control their emotions. They also want traders with a comprehensive understanding of the markets traded and a solid knowledge of fundamental and technical analysis.

The interview stage is the process you expect when applying for a normal job. You first express your interest in joining the Prop Firm by enquiring and completing an application form that states your professional experience and education. This is usually followed up with an interview to discuss the position, historical performance, and the trading strategies you have employed or are currently using.

The challenge stage, the more common and popular route in use today, is a defined and structured entry process designed to demonstrate trading skill and to establish that you are a profitable trader who can manage risk. If you should pass the Prop Firm’s challenge, this can open the door to Prop Trading Capital and the opportunity for increased earnings. The Prop Firm’s challenge will include things like specific performance goals and drawdown limits. For example, a challenge may be to generate a 7% return with a maximum drawdown of no more than 4%. Many Prop Firms will first evaluate a trader’s performance on a Demo Trading Account.

Prop Trading Strategies

How a Prop Trading Firm trades varies widely, as do the markets traded.

Prop Firms usually provide their traders access to sophisticated software, offering real-time data feeds and premium news, which can give them a small edge over many retail traders.

Prop Traders employ different strategies based on their skills and experience and regularly specialise in one market. These can range from merger arbitrage, index arbitrage, and volatility arbitrage strategies, together with high-frequency trading, to global macro trading and news event trading which incorporates a blend of technical and fundamental analysis.  

The financial instruments traded include the foreign exchange market (Forex market), bonds, commodities, and derivatives products like options, futures, and CFDs (Contract for Differences).

Proprietary Trading FAQs:

1. What is Proprietary Trading?

Proprietary Trading, or ‘Prop Trading’, occurs when a Proprietary Firm trades the financial markets using its own capital. Prop Traders are generally commission-based.

2. How does Prop Trading work?

Prop Trading employs the Prop Firm’s capital to trade the financial markets. These trades are carried out by the Firm’s Prop Traders, who work with several strategies.

3. How does a Prop Firm trade?

How a Prop Firm executes trades will differ, depending on the Firm and the Prop Traders. Common Prop Trading strategies include index arbitrage, volatility arbitrage, and high-frequency trading to global macro trading.