What is Prop Trading?
Simply explained, proprietary trading – also known as prop trading or prop, is when a firm trades for profit instead of commission revenue. Essentially, the firm has decided to profit from the market rather than from processing trades (execution costs).
The theoretical origins stretch back to the Bucket Shops of the 1920. A Bucket Shop was an establishment that allowed the registration of bets, or wagers; usually for small amounts, on the rise or fall of the prices of stocks, grain, oil, etc. However there was no actual transfer or delivery of the stock or commodity.
After Small Order Execution System (SOES) was implemented after the 1987 stock market crash, individual investors were able to execute electronic trades directly to the market. This gave the same access to orders and execution to the general investor as larger institutional traders and firms. Market makers were forced to accept SOES orders that matched the advertised National Best Bid/Offer (NBBO). This levelled the playing field and laid the groundwork for our industry.
Bank engaged in raising capital must ‘make a market’ and to do this, an investment bank employs traders. Over time these traders began to devise different strategies within this system. Private companies emerged in the late 1990’s that mimicked the banks model, but targeted small independent investors. These ‘prop shops’ combined direct market access with low cost execution and built high-tech, high-touch trading communities. Over time, technology and broadband internet allowed many prop firms to begin offering remote access; and the industry was born.
Proprietary traders trade the prop firm’s capital and therefore have access to virtually unlimited buying power. Since this is not a leveraged account the trader’s personal capital is not at risk. In exchange, the prop firm awards the trader a substantial bonus on (most of) the profit generated in the market. Since trade costs are based on executed share volume, larger prop firms are able to leverage the total trading volume of the firm to qualify for the lowest tiered pricing. This discount is almost always passed onto the prop trader, making proprietary trading considerably less expensive than a retail or discount broker.