Introduction to Proprietary Trading – How Does it Work?
Definition: Proprietary trading, or Prop trading is a term used to describe the activity of a company whose traders actively trade equities, futures or other products using the firms money as opposed to their own or a client’s money. The company puts up all the risk capital and margin money (proprietary funds), and takes liability for losses. Profit generated from trading activities are split between the firm and the trader.
Individual traders are almost always self employed. The trader does all the "work" by trading and taking speculative positions in the markets, with a view to generating profits.
Each trader pays for the facilities that he makes use of for his trading, through a desk fee or seat charge. A typical desk fee can range from £1,000 to £3,000 per month, and would include some combination of sophisticated trading tools, market data, analytic package, newswire feed, market connectivity and high speed order routing technology, depending on the software and systems that the trader wants to make use of at his desk.
The prop firm and its traders collectively generate huge trading volumes in the markets they participate in, which translates into economies of scale for all the traders enabling very low-cost clearing fees. Additionally, the prop firm will often have its own membership with the exchanges, meaning that the per-trade fees that the exchange charges to each traders’ account when they make a trade are greatly reduced. A typical retail futures brokerage such as TradeStation charges $6.99 per contract traded in the Bund futures, by comparison a typical prop firm is able to offer around €0.32 EUR per contract traded in this market – a trader making just 75 trades a week with a single futures contract, would stand to save over $3,700 each month in commissions alone.
Origins of prop trading
Electronic trading firms have been springing up since talk of the demise of the trading floors began more than a fifteen years ago. When the then-Deutsche Terminborse (now Eurex) launched its trading platform in the early 1990s, tech savvy traders took notice.
As more contracts became available electronically, proprietary electronic-only trading firms began to crop up, mostly in London and Chicago, but it wasnt until the London International Financial Futures and Options Exchange (LIFFE) shut down its open outcry trading floor in 2000 and converted their markets into fully electronic exchanges, launching the Connect platform that they became more of a force in the marketplace. Not only was a new platform available to traders, it was the first "open" architecture system that allowed independent service providers and brokerage firms to develop their own front-end order routing technology. In addition, a whole community of sophisticated former floor traders was on the street looking for a way to salvage their livelihood and duplicate some aspects of the floor trading environment. Many of these former floor traders formed their own proprietary trading firms as they made this transition.
History is repeating itself in Chicago where, although the floors have not closed, the number of electronic trading firms has grown in volume and influence over the last ten years as the liquidity in the major contracts has moved into the electronic markets. While there is no reliable data available to the public on the share of the futures trading that these firms represent, anecdotal evidence suggests that it is significant. In fact, some of these firms say their daily volume across markets exceeds the total daily volume of any one of the four big futures exchanges. Euronext estimates that independent traders, its term for individuals and firms trading for their own accounts, make up about one-third of the entire universe of people trading on its Connect platform, and account for as much as 50% of the volume in its short-term interest rate STIR futures contracts.
The trading screen has now replaced the exchange trading floor or “pit” and an order to buy or sell that would formerly have been executed by a shouting floor trader in a colourful jacket can now be done in milliseconds at the click of a mouse button.
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