Wall Street firms in the form of mutual funds, hedge funds as well as investment banks are best known for trading clients’ money in the markets. While leveraging various advanced trading strategies to detect entry and exit points, the firms also deploy manual trading as well as automated trading to trade multiple securities. Similarly, the firms also leverage forex expert advisors to trade currency pairs as well as for cryptocurrencies on behalf of clients. However, that is not always the case.
In addition to trading clients’ money, Wall Street firms also do trade their own money. Conversely, proprietary trading is the process by which large financial firms invest their own money. In this case, the firms use their own money to engage in hedging, scalping, position trading, or long term investment in the markets.
Prop trading sees financial institutions choose to profit from market activities while trading various securities and forex products rather than benefit from thin margin commissions charged on clients’ trading activities. Likewise, proprietary trading involves the trading of currencies, stocks, bonds as well as commodities, among other instruments.
Proprietary Trading History
Proprietary trading has its roots dating back to the early 1980s at a time when hedge funds were cropping up in numbers. Experienced traders who had years of experience working in investment banks saw the need to pursue a new challenge instead of working for financial institutions.
The experienced traders consequently parted ways with their firms, and instead of starting up firms and raising capital from investors for trading purposes, they opted to start firms to trade their own money. The early proprietary trading firms were mostly made up of traders with vast experience in the capital markets. The traders pooled their years of experience and capital and started trading their own money.
The proprietary trading industry has grown to great strengths since the early 1980s. However, in 2008 the firms experienced significant financial challenges triggered by the financial crisis. Some of the firms went under, as most of them were highly leveraged.
The best performing prop firms at the peak of the 2009 financial crisis went on to poach some of the top-performing traders from some of the less successful firms. In some instances, profitable prop firms ended up buying other struggling firms in the proprietary space.
How Proprietary Trading Works
The same way retail traders set up trading accounts and study chart patterns and use forex charting tools, among other forex trading instruments, is the same way prop firms engage in proprietary trading. Instead of using client money, prop firms use their capital and balance sheet to conduct self-promoting transactions.
The trades carried out as part of proprietary trading are usually speculative and executed through a variety of derivatives and complex investment vehicles. In addition to placing trades manually, prop firms also leverage automated trading strategies such as Algorithmic FX trading in a bid to get an edge in the market. The use of forex EA in addition to using some of the best forex indicators as deployed by retail investors also comes into play.
Profits Splitting in Proprietary Trading
Proprietary trading firms pool together highly successful and experienced traders to be able to trade various securities from a large pool of money. In exchange for the capital that the traders use to make trades, profits generated are usually shared between the traders and the firm.
Depending on the firm size, the profits can be split between 10% and 30%. The size of the trader’s account in the broader trading account also determines a great deal the amount of profits they get to walk away with.
The ability to trade a much bigger capital pool is one of the reasons why traders come together and form a prop firm. In most cases, proper position sizing, as well as risk management, allows traders to rack in more profits in gross dollars as compared to if they were working as retail traders.
Why Firms engage in Proprietary Trading
One of the reasons why financial institutions engage in proprietary trading is to boost their quarterly or annual profits. In addition to generating some returns from trading commissions, the firms deploy their capital to be able to lock in all profits generated from trades placed.
Proprietary trading allows financial institutions to realize 100% of the gains earned from investments placed, be it as part of news trading, trend trading, or arbitrage. In this case, the firms can deploy strategies using fundamental analysis or strategies using different technical indicators to ensure that all the capital put to use generates optimum returns.
While prop trading, financial institutions can stockpile up on inventory of securities. By stockpiling, the firms can prepare for down and illiquid markets whenever it becomes harder to purchase securities in the open market.
Similarly, by using their capital, prop firms can become influential market makers by providing liquidity in the market. If the firms take out a significant position depending on the security being traded, they can end up dictating the direction in which the market moves.