The ugly side of prop trading firms: What you don’t see, they don’t tell.

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You have probably heard about prop trading firms that let you “trade with their capital?”

The concept sounds appealing, but how does prop trading work?

Many people assume that most of the stock market trading volume comes from individual retail investors. This is not the case.

Apart from retail traders, several firms, institutions, and corporates take part in the day-to-day stock market activities.

Beginner investors who are about to dip a toe in financial markets often face the dilemma of whether to go for retail or prop trading.

To help you make an informed choice, this guide will tell you everything you need to know about prop trading.

What Is Proprietary Trading?

Proprietary trading is when a trading desk at a financial services firm (investment bank, broking house, commercial bank) invests the firm’s capital for direct market gain.

Prop firms believe that they have a competitive advantage that will help them earn an annual return that exceeds bond yield appreciation, index investing or other investment styles.

Although risky, prop trading can prove very lucrative for prop firms as they take all the returns from a trade instead of just earning a commission for processing positions.

What Segments Do Prop Trading Firms Focus On?

Prop trading may involve the trading of stocks, bonds, currencies, commodities or other instruments.

While prop firms involve themselves in the equities segment, their key focus is on derivatives (futures and options). The main reason for this preference is that the trades they make are almost always purely speculative.

Prop traders use a combination of trading strategies such as technical analysis, fundamental analysis, global macro trading and various arbitrages to execute trades.

How Does Proprietary Trading Work?

The concept of prop trading is pretty much straightforward.

Prop firms focus on market-making. When a client wants to trade a highly illiquid security or a considerable amount of a single security, chances are there are limited buyers or sellers for this type of trade.

As such, the prop firm will act as the buyer or seller and initiate the other side of the client’s trade. They would then purpose to sell the entire volume at a higher price to profit from the overall trade.

Since prop firms use their own funds, they can take on a higher level of risk as they are not answerable to their clients. All profits or losses made have to be borne solely by the entity itself.

Why Do Financial Institutions Engage in Prop Trading?

They do this for corporate self-interest.

You see, financial services firms operate on thin margins due to the stiff competition in the industry.

Revenue collected from their primary business activities may be insufficient to sustain them in the long run. So, they engage in prop training to profit and use the revenue earned to sustain their business and further their goals and objectives.

Another reason financial services firms indulge in prop trading is because they tend to have the edge over retail investors.

Besides benefiting from advanced trading software, they also have faster and better access to high-level, price-sensitive info which they can use to their advantage.

How to Become a Prop Trader

Prop firms recruit talented traders to optimize their earning potential.

If you’re an experienced trader looking to leverage your skillset, prop funds can be an attractive prospect.

But it’s not just veterans; the trading environment at prop firms can help nurture beginners.

The best opportunities let you start your journey with little to no investment from your side. There’s no risk of losing your own capital either, which makes prop trading a great option for beginners with limited capital.

You may, however, be required to cover the cost of the training program and pass a qualification test to prove that you have what it takes to make it in the financial markets.

A prop firm will pay you based on a profit split commission plan, where you and the firm share the outcome of your performance.

Volcker Rule

Alongside hedge funds, banks were among the financial institutions experts accused of causing the 2008 financial crisis.

On April 1, 2014, a federal regulation called the Volcker Rule was implemented to protect bank customers. Under the rule, banks are restricted from making speculative investments that don’t benefit their clients directly.

Named after Paul Volcker, a former Federal Reserve Chair, the rule also limits the amount of risk that a financial institution can assume.

On June 25, 2020, the FDIC promised to ease the restrictions of the Volcker Rule.

Pros

· Higher quarterly and annual profits

Prop firms earn revenue in the form of fees and commissions, which represent a tiny percentage of the total amount invested/gains generated. They get to keep 100 percent of returns.

· Market making

Prop trading allows firms to be market makers. Firms with particular types of securities can offer liquidity for their investors on a specific or group of securities.

· Stock of securities

Prop firms are allowed to keep an inventory of securities. This can help them to prepare for illiquid or down markets when buying/selling securities on the open market become harder.

· Sophisticated technology

Prop traders enjoy access to advanced platforms and other exclusive software that allow them to indulge in high-frequency trading.

· Reduced risk

Since prop traders trade with the firm’s money, there’s no risk of losing your own capital.

· Flexibility and decent salary

Prop trading offers the best of both worlds — the freedom to work remotely and a handsome income. Skilled traders looking to leverage their investment knowledge can trade from home and earn a base salary that starts at $100k plus a bonus (a percentage of the base salary).

Cons

· Intense trading hours

Depending on the prop firm, the markets you trade and your seniority, prop trading hours average around 50 hours a week.

· Tough competition

Firms expect decent ROIs. Delivering on such expectations requires skill. If you don’t perform, they will find someone else to do it.

· Limited exit opportunities

If you decide that prop trading is not for you, the skills you have acquired are very specific and you may not find them useful in other environments.

Prop Trading Scams

Prop trading scams exist and you should do due diligence before signing up to a prop firm to avoid getting scammed.

Here’s how to spot a scam prop firm:

· Low-quality website

· No or limited Trustpilot presence

· Not mentioned by other traders online

· No social media presence

· Unusual funding options

· Lack of phone support/live chat

If the firm you’re eyeing has many of these features, I’d advise staying clear.

Thankfully, there are lots of legit prop firms like Ikan Bilis– you really don’t need to experiment with riskier options.

Happy trading!