What is Prop Trading? (2024)

If you've ever looked for a job that focuses on making profits in the markets, you’ll probably go down the rabbit hole of learning about proprietary trading, also known as prop trading. But what is prop trading? Prop trading is a trading activity where financial firms use their capital to trade in the financial markets to earn profits. However, this field is highly demanding and competitive, requiring exceptional skills, knowledge and discipline. So, if you're interested in discovering the intricacies of prop trading, read on.

How Does Prop Trading Work?

Proprietary trading involves financial firms trading in the financial markets using their capital instead of acting as an intermediary for clients. Rather than making money from commissions by trading for clients, firms take positions to potentially pocket the full profit from trades. Traders within these firms use the company's resources to trade stocks, bonds, currencies, commodities and derivatives.

Traders may have autonomy over their trading strategies and decisions as long as they stick to the firm's risk management guidelines and meet performance targets. Profits generated by the prop traders are shared with the company, and traders also bear a percentage of the losses incurred.

History of Proprietary Trading

Initially, proprietary trading was used to describe trading desks within investment banks that use the bank's funds to trade securities. These traders work separately from the teams that are managing bank clients.

However, after the 2008 financial crisis, the Volcker Rule prohibited banking entities from engaging in proprietary trading, which meant that financial institutions began to separate their investment banking and proprietary trading teams from lending departments. This regulation led to a decline in proprietary desks within banks and the growth of independent proprietary trading firms, commonly known as prop shops.

Most prop shops are specialized entities that manage capital allocated between traders. Profits and losses are shared with traders based on predetermined percentages. While some firms hire selective talent, others provide opportunities to individuals who pass specific tests or pay fees.

Types of Proprietary Trading Firms

Proprietary trading firms can be categorized by the markets they operate in, their strategies and their organizational structure. Here are some common types of prop trading firms and how they function.

Regulation and Risks in Prop Trading

Proprietary trading is governed by regulations and oversight, which vary depending on the jurisdiction, market and firm. The following are some of the standard rules that impact prop trading.

• Volcker rule: The Volcker Rule was introduced in the U.S. after the 2008 financial crisis as part of the Dodd-Frank Act. It limits banks and their affiliates from engaging in prop trading and using depositor funds for speculative purposes. Banks are required to separate their prop trading activities from client-related activities and report their prop trading activities to regulators.
• MiFID II: The EU implemented this directive in 2018 as part of EMIR to improve financial market transparency and efficiency and protect investors. The directive mandates prop traders to register as market makers, limit dark pool trading and report trades and positions to regulators.
• Basel III: This framework was developed by the Basel Committee on Banking Supervision in response to the 2008 financial crisis to enhance the banking system's stability and reduce systemic risk. The framework imposes higher capital, liquidity and leverage ratios on banks regarding their trading activities, impacting prop trading.

Prop trading carries risks, such as market, liquidity, credit, operational and legal risks. Prop traders must know these risks and use appropriate risk management tools and techniques, such as stop-loss orders, hedging, diversification and stress testing.

Skills and Qualifications for Prop Traders

Prop trading is a highly competitive and demanding field that requires specific skills and qualifications to succeed. Key skills for prop traders include:

• Analytical skills: Prop traders use data analysis to make educated decisions based on market patterns and trends, understand market fundamentals and technicals and utilize various tools and models to support their analysis.
• Quantitative skills: Prop traders use mathematics, statistics and programming to create and evaluate their trading strategies and algorithms. They should know various software and platforms, including Excel, Python, R, MATLAB, MetaTrader and Bloomberg.
• Psychological skills: To be a successful prop trader, you must possess mental and emotional discipline, self-control, confidence, motivation and the ability to handle stress, uncertainty and volatility.
• Communication skills: Prop traders need to possess strong communication skills to work effectively with colleagues, managers and regulators. They must present their ideas and results clearly and convincingly, work well in a team and collaborate and cooperate with others.

Prop traders typically have a degree in finance, economics, engineering, mathematics, computer science or related fields. Some traders have advanced degrees or professional certifications like CFA, FRM or CAIA or personal trading experience.

Benefits of Proprietary Trading

Proprietary trading is a lucrative career option for skilled and passionate traders. It offers numerous benefits, such as:

• High earnings potential: Prop traders can earn a lot of money through a combination of salary, bonus and profit share. Top performers can substantial amounts annually, perhaps above six figures.
• Career growth opportunities: Prop trading provides a promising career path for traders, allowing them to advance from junior to senior positions. Traders can also leverage their skills and experience to pursue other careers such as hedge fund manager, portfolio manager, financial analyst or consultant.
• Creative freedom: Prop trading provides traders with freedom and flexibility to pursue their interests, choose their own trading style, strategy, market and instrument and experiment with different approaches and techniques. Prop traders can enjoy the challenge and satisfaction of solving complex problems and finding profitable opportunities.

Challenges and Outlook of Prop Trading

Prop trading is a highly competitive industry in a dynamic marketplace that moves quickly because of advancements in technology and innovation. Prop traders must continuously improve their skills and knowledge to adapt to changing market conditions and customer demands while facing pressure from their firms and peers to maintain high performance and quality.

Regulations and oversight have become more stringent and complex, reducing opportunities and accessibility of capital, liquidity and information. Additionally, prop traders must anticipate and prepare for the potential impacts of disruptive technologies like artificial intelligence and machine learning.

Successful Prop Trading Example

Jane Street is a highly successful prop trading firm founded in New York in 2000. The company is known for its global liquidity provision and market making. Jane Street traded more than $17 trillion worth of securities in 2020, putting it among the largest traders globally. The company also boasted a $10.6 billion revenue in the year ended in March 2021.

The success of Jane Street can be attributed to its use of cutting-edge technology and hiring some of the best and brightest talent in the industry. The company's culture is flat and collaborative, encouraging everyone to share their ideas and opinions and learn from each other.

Best Prop Trading Firms

Choosing the best prop trading firm depends on the location, market, strategy, compensation, training, support and fit. However, based on general criteria, such as size, reputation, performance, diversity and innovation, here are some of the best prop trading firms in the world.

Prop Trading: Complex, Rewarding Frontier

Proprietary trading is a field where firms use their capital to try to earn market profits. Success in this field requires hard work, technical expertise and adaptability. However, challenges like competition and a fast-paced industry mean firms have plenty to keep up with.

Frequently Asked Questions