What is Proprietary Trading?

Introducing Proprietary Trading: How It Works

The definition of proprietary trading, or "prop trading" is activity whereby a company's traders trade equities, futures, or other products actively, using money staked by the firm instead of their own capital, or a client's money. In other words, the company takes on the risk and puts up the capital and margin money (also known as proprietary funds), and then takes any liability for losses on itself. Whenever there's profit from this kind of activity, the firm and the trader split the profits.

It's almost always true that individual prop traders working at a firm are self-employed. The traders take speculative positions in the market using the company's money with the intention of generating profits.

Each trader pays for the facilities he or she uses when trading, with something called a "desk fee" or "seat charge." This ranges widely but a trader may typically pay out between $1000-$5000 per month, depending on the services he requires for his trading. The desk fee cost includes sophisticated tools such as analytic packages, market data, exchange connectivity, newswire feed, and low latency order routing technology.

Proprietary firms and their traders generate huge trading volumes collectively, within the markets they trade in. This means that there are economies of scale, resulting in low-cost clearing fees for company traders. The prop firm usually also often has its own membership with the exchanges, meaning that each trader's account per trade fees and exchange charges are greatly reduced for trade. Typically, a retail futures brokerage like TradeStation charges a fee of $6.99 per contract traded in Bund futures; that's compared to a proprietary trading firm who would commonly offer fees as low as 0.32 EUR per contract traded in the market. That means that a trader who makes just 75 trades a week with a single futures contract and save over $3700 a month in just commissions.How did prop trading start?

Open outcry trading floors began their demise more than 15 years ago, and electronic trading firms have sprung up to fill the gap. In the early 1990s, Eurex (originally Deutsche Terminborse) launched its trading platform, and traders who were tech savvy paid attention.

More contracts began to become available electronically and, as this happened, electronic only proprietary trading firms began to spring up, primarily in Chicago and London. The London International Financial Futures and Options Exchange (LIFFE) shut down its traditional trading floor in 2000 and began to operate fully with electronic exchanges at that point; also at that point, it launched its Connect platform that has made it truly a force in the marketplace. It meant that a new platform was available to traders, true, but it was also the first architectural system that was truly "open," allowing independent service brokerage firms and providers to develop individual order routing technology that was front end. Besides that, former floor traders, sophisticated in their own right, were on the street looking for a new way to support their livelihoods and utilise the skills learned in the floor trading environment. Many former floor traders established their own prop trading firms as they transitioned to the electronic environment.

Now, in Chicago, history is repeating itself; although open outcry trading floors have not closed (yet), electronic trading firms are becoming increasingly commonplace and have increased their influence over the last decade as major contracts' liquidity has moved into electronic markets. There is no truly reliable data that shows the public how much of the futures trading done is actually done by these firms, but anecdotal evidence inidicates that it's significant. Some of these firms, in fact, say that the collective prop trading volume across all markets is greater than the total daily volume of any one of the four major futures exchanges. Euronext has said that the individuals and firms trading for their own accounts (also known as "independent traders") comprise about one third of all participants trading on its Connect platform, a constituting as much as half of the volume of its STIR (short-term interest rate) futures contracts.

Increasingly, the electronic trading screen is taking over from the "pit," or trading floor, with buy and sell orders increasingly done in milliseconds, at the click of a mouse, instead of through the traditional medium of the colourfully attired and shouting floor trader