Prop Trading 101

Proprietary trading, or “prop trading” for short, is when a firm uses its own capital to trade the markets and attempt to extract a profit. Prop traders are the people who do this job. They are allocated capital by the firm to trade a specific market or strategy that they specialize in. Prop traders don’t have clients like a stockbroker, instead their only job is to trade the firm’s capital and make money out of money. Proprietary trading is done by big banks–which trade hundreds of millions of dollars in assets each day, and mostly hire experienced traders– as well as small boutique firms, which hire experienced and inexperienced traders, train them and then provide capital to trade with.

Proprietary Trading at Large Institutions

Proprietary trading at major financial institutions, such as banks, is on the decline due to conflicts of interest with clients, and the potential for investors’ money to be at risk when speculative positions on the prop trading desk take a nose dive, like what happened during the financial crisis in 2008.

Traders on these large proprietary trading desks have strong academic backgrounds and usually some trading experience. Mathematicians and computer programs are in high demand, as automated strategies that attempt to capture inefficiencies in the market at lightning speed are a highly lucrative field. Since about 2005 the amount of “quantitative” or computer- and math-based trading is growing; computers can supposedly do the same job faster and more efficiently than a live trader.

Proprietary traders for large institutions are employees of the company for which they work, and are typically paid hefty salaries since they control large amounts of capital. Bonuses are awarded based on performance.

Since there are few proprietary trading jobs at large firms, this isn’t a career path many people will get to experience. Below we focus on smaller boutique proprietary firms, which are more accessible to those looking to trade for a career.

Proprietary Trading at Small Firms

Throughout the country and around the world there are proprietary trading firms in most major cities. These firms will each be slightly different since they are often independently run.

Who They Hire

These firms typically hire both experienced and inexperienced traders from a diverse array of backgrounds (not necessarily finance).

Most of these firms focus on day trading; day trading is less capital intensive since margin requirements are lower if you don’t hold positions overnight. Some firms may allow swing trading.

Training

Most firms offer a training program that teaches new traders about the markets. The quality of the training will vary greatly from firm to firm; some firms will provide you with proven strategies to follow, while others won’t teach you anything and expect you to create your own profitable strategies.

If you’re an inexperienced trader looking to join a proprietary trading firm, ask questions about the training and whether they provide you with strategies. High quality training will help you progress more quickly.

Capital

The business of a proprietary trading firm is to turn their money into more money. These firms, therefore, provide traders with capital to trade; if the trader makes money, the firm makes money.

Some firms provide traders with all the capital they need to day trade; this may be millions of dollars.
Other firms will require that the trader put up some of their own money. This helps the firm reduce its own risk as the money can be used to offset losses the trader may take. Experienced traders with a strong trading history may not be required to put up any of their own money.

Overall, a proprietary trading firm provides access to more capital than most traders could access on their own. This allows for a greater likelihood that the trader can actually make a living off trading.

Pay

Most small proprietary trading firms do not pay a salary; you are paid based on your trading performance. You’re not an employee; rather you are contracted by the firm to trade their capital.

For pay, you will receive a percentage of your profits. This ranges from 50% to 100% of the amount you pull out of the markets each month. Firms that pay 50% of your profits typically have very low trading fees. Firms that pay out a 100% of profits are making money somewhere else, typically off commissions or charging you other fees for accessing their capital and trading floor.

With this notion in mind, the payout percentage isn’t the only thing to consider when choosing a proprietary trading firm to work for. Very high fees can make it hard to make a profit; low fees make it easier to produce a profit, so 50% to 80% of something is better than 100% of nothing [see also Moving Average Trading Strategies: Do They Work?].

Under this model it may take several months or more before the trader receives a paycheck; it takes time to become profitable. Also, the company will allocate larger amounts of capital to the trader only after they prove themselves with smaller amounts.

There are a very small number of proprietary firms that hire you as an employee and pay you a salary until your profits are enough to produce an income. Signing a contract may be required, which prevents you from just collecting the salary and then leaving once you are profitable.

Trading Floor or Trading Remotely

Previously, all proprietary trading firms had physical offices, but with high quality infrastructure it’s now quite common for proprietary traders working from home. Referred to as “remote traders,” these individuals trade outside the physical office and are typically experienced, with a strong history of discipline and risk control. Trading remotely may require an additional deposit to offset losses the trader may incur due to personal system failures.

Traders on the trading floor carry less risk for the firm because the traders can be physically monitored, and if either a software or hardware failure occurs there are multiple people around to help resolve the issues.

The Bottom Line

Prop trading is an exciting field. Prop traders are provided with capital to trade, for the sole purpose of producing solid returns day in and day out. Salaried prop trader positions are in short supply and will typically require a high level education and/or an extensive profitable trading history.

Small firms offer prop trading opportunities, and capital to trade, to nearly anyone with a desire to learn and discipline to stick through the both tough and long process of becoming a consistent trader. Each small firm will be different and operate under a slightly different model. There are proprietary trading firms available in most cities, via physical location or remote access. If you join one, be sure to research their pay structure and training program so you’re assured the highest chance of success. With most small firms you are not an employee, you’re a contractor and it may take several months or more before you are able to make a living off your trading.