What is Proprietary Trading?

Proprietary trading refers to a financial firm or commercial bank that invests for direct market gain rather than earning commission dollars by trading on behalf of clients. Also known as “prop trading,” this type of trading activity occurs when a financial firm chooses to profit from market activities rather than thin-margin commissions obtained through client trading activity. Proprietary trading may involve the trading of stocks, bonds, commodities, currencies or other instruments.

Financial firms or commercial banks that engage in proprietary trading believe they have a competitive advantage that will enable them to earn an annual return that exceeds index investing, bond yield appreciation or other investment styles.

Key Takeaway

Proprietary traders may execute
an assortment of market
strategies that include index
arbitrage, statistical arbitrage,
merger arbitrage, fundamental
analysis, volatility arbitrage,
technical analysis and/or
global macro trading.

How Does Proprietary Trading Work?

Proprietary trading, which is also known as “prop trading,” occurs when a trading desk at a financial institution, brokerage firm, investment bank, hedge fund or other liquidity source uses the firm’s capital and balance sheet to conduct self-promoting financial transactions. These trades are usually speculative in nature, executed through a variety of derivatives or other complex investment vehicles.

Benefits of Proprietary Trading

There are many benefits that proprietary trading provides a financial institution or commercial bank, most notably higher quarterly and annual profits. When a brokerage firm or investment bank trades on behalf of clients, it earns revenues in the form of commissions and fees. This income can represent a very small percentage of the total amount invested or the gains generated, but the process also allows an institution to realize 100% of the gains earned from an investment.

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