If you don’t completely understand what proprietary trading is, that’s okay. You’re not alone. There’s a lot of confusion out there, even though the term itself isn’t particularly complicated.
Proprietary trading is simply trading that is done with a person or firm’s own money. That’s it. If you work for a company that trades and invests its own money rather than raising funds from outsiders, that’s proprietary trading. If you trade your own money through your own brokerage account, you’re engaging in proprietary trading.
So where’s the confusion?
Things get complicated because two very different types of financial companies engage in proprietary trading. For the sake of this article we’ll call them Wall Street prop trading firms and Main Street prop trading firms.
After the financial crisis of 2008, financial regulatory agencies implemented the Volcker Rule, which prohibited banks from proprietary trading so they could no longer trade bank funds in order to make a profit. Proprietary trading was not outlawed, it just moved to different firms.
These new proprietary trading firms are sort of like hedge funds, in the sense that they use sophisticated techniques to trade for profits, but they trade their own money rather than accepting money from clients. Wall Street style prop trading firms hire traders who often have advanced degrees or preternatural mathematical skills like Will in Good Will Hunting.
What I’m calling Main Street proprietary trading firms offer traders of any level of education or any background the ability to trade the firm’s capital. A Main Street prop firm will fund anyone who can prove they can turn a profit, and then split those profits with the trader according to a predetermined split percentage. How do you like them apples?
The benefit of joining a prop trading company, regardless of which type you join, is that you are trading someone else’s money. Unless you are already independently wealthy—in which case you should be on a beach somewhere not learning about proprietary trading—this means you’ll have a lot more capital at your disposal. More capital means the opportunity for more profits, and prop traders always receive a percentage of their profits.
Trading someone else’s money also means you won’t lose your own money in case things go wrong. If you fail, you’ll fail cheaply and won’t end up taking out a second mortgage on your home to cover your trading debts.
Main Street prop trading firms also provide a great opportunity to learn trading in a real trading environment without risking anything more than your sign-up fee. If you become a successful prop trader, you can also have the freedom to trade whenever you please from wherever in the world.
Proprietary trading, in any form, doesn’t allow for a lot of job security. If you’re trading a firm’s money, but consistently losing it, you won’t be trading with them for very long.
Wall Street style prop trading firms offer a little more security in that they pay you a salary plus a percentage of your profits. So even if you’re not making enormous profits, you can still pay your bills. However, even some successful Wall Street traders have been losing their jobs thanks to some unlikely competition—robots. Machines aren’t just replacing factory workers, they’re pushing out Wall Street traders too.
Main Street prop trading firms offer even less security. You’re technically a contractor, not an employee, so you can forget about health insurance or other benefits. The only money you’ll take home is a percentage of your profits, nothing else.
That can put you in a very tough spot, because the market doesn’t care if you need money to pay your electric bill. It won’t present you with good trading opportunities when you need to make some money. This causes many traders to take on too much risk, which can lead to disaster.
To become a trader for one of the big Wall Street type prop trading firms, you most likely will need a degree from an Ivy League-level school or you’ll need to be plucked from your janitor job after you solved one of the world’s most difficult math problems between broom sweeps.
That’s a slight exaggeration, but it is extremely difficult to join a Wall Street prop firm as a trader. You have to demonstrate extraordinary mathematical skills or an incredible understanding of computer science. That’s because many proprietary trading firms develop incredibly complex algorithms or automated trading systems to give them an advantage in the market.
It is quite a bit easier to become a Main Street style prop trader, but you will have to pay for the privilege. Main Street prop firms ask for either a one-time or monthly fee, and after you pay that fee you have to pass one or two trading challenges to prove that you can execute a profitable trading strategy and adhere to strict risk management rules.
If you can’t meet your profit targets or follow the firm’s trading rules, you lose your fee and have to pay for a new account and start all over. If you pass the challenges, you are funded to the amount you signed up for, which can be anywhere from $10K up to $1 million.
You can then trade that money and get a split of any profits you make, keeping up to 90%. If you lose money, that comes out of the firm’s pockets, not yours, but you’ll probably lose your account. You can also lose your account if you don’t continue abiding by the firm’s trading parameters.
Traders who abide by the rules and turn a profit can do very well for themselves, without putting much of their own money on the line.