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How Does A Prop Trading Firm Work?

How Does A Prop Trading Firm Work?

There are typically three main ways in which traders structure themselves, make money and succeed, but in the fast-moving world of trading, there is a lot of overlap between the different types.

There are individual traders, who work with brokers and the apparatus of the markets to trade with exchanges directly, and on the other side are investment companies who receive money from clients to invest in the market in exchange for a share of the profits.

The third option is a prop trading firm, which rests in between the two extremes and has become extremely popular in recent years due to the rise of instant funding firms and online trading platforms to allow anyone in the world to invest.

What is a prop trading firm, how does it work, and how does it make money for everyone involved?

What Is Prop Trading?

Prop trading is short for proprietary trading, which is used simply to define trading institutions that use their own capital to invest in various financial markets rather than money from clients.

That is the simplest explanation, but in practice, a proprietary trading firm often structures itself somewhat differently from an investment firm, and in fact, if a financial company operates both a client investment fund and a proprietary trading desk, the two must be separated using an ethical wall.

There is a single, huge, very obvious risk to firms trading using their own money compared to client money, namely that they are risking their own capital and a particularly unsuccessful trade, margin call or short squeeze could cause huge losses.

However, the benefits of such an approach are so substantial that it offsets this potential risk and makes it a worthwhile approach for many investment firms.

The first one is that whilst an investment firm often relies on commissions and fees to make money from clients and thus generally needs to operate at scale in order to make substantial profits, a prop trading firm gets to keep all of the revenue for itself.

As well as this, prop firms can use any investment strategy they want to make money, which can involve complex derivatives, markets such as forex and futures, and other strategies that are sound, diverse and managed but might not be the types of investments that clients traditionally want to make.

This latter point also affects the structures of many prop trading firms and leads to the cluster of affiliated prop traders and profit split arrangements that are most commonly associated with prop firms today.

Prop firms are often the first place that unorthodox investors will develop their skills, network and become well-rounded traders, particularly those who have entered the financial market by transitioning from another profession.

Creative minds are prized by prop firms due to the greater freedoms involved, and successful traders who can sustain that success are the types of traders that proprietary trading wants to recruit.

This leads to an interesting mirror arrangement where prop trading firms will often provide generous profit-sharing arrangements with traders who have proved their ability to effectively manage accounts.

For traders, the benefits are that they can access far more capital than they would otherwise be able to as individuals unless they happened to have a high net worth. 

This means that certain markets such as forex are far more viable, as the constant liquidity and small market movements tend to be primarily profitable endeavours for accounts with large amounts of capital.

It also provides a platform for traders to develop their skills and learn the right way. Whilst the initial investment means that complete beginners should obviously avoid trying to join a prop firm until they know what they are doing, people who pass the test will likely become more effective traders whichever markets they settle on.

Whilst a trader’s freedom is not completely unlimited, as traders are required to exercise risk management and avoid particularly risky moves such as trading the news or high-frequency trading, there is a lot more scope and support for creativity on the market than there would be in a traditional investment firm.

For prop firms, the benefits more than outweigh the risks, and the primary hedge for them is the evaluation programmes and application fees for prop traders.

Most overly aggressive, reckless or outright bad traders will be filtered out through the evaluation system before they cause harm to a firm, leaving only traders that are likely to be able to succeed in the long term.

Ultimately, prop firms work by creating a support network of traders and developing a symbiotic relationship where the firm receives creative trading strategies in exchange for providing capital to investors.