What Is Proprietary Trading?

Proprietary (or prop) trading is a high-risk form of trading where instead of acting on clients orders and receiving commission payments, the trader assumes his own position with the capital of the firm. This means they will experience the full profit or loss of the position. Prop trading firms trade electronically and the traders can use the leverage of the firm to magnify returns (and losses).
Prop trading has been responsible for some large losses and there is a risk of moral hazard (the trader is using the firm's capital and therefore may take more risks) but is also usually the most profitable part of an investment bank. Prop traders usually have access to extremely sophisticated software and information to enable them to gain a competitive edge. Under the Dodd-Frank legislation and Volcker Rule, prop trading is being made more and more difficult to do and is now only allowed by 'important' firms for hedging purposes.

Prop Firm vs Hedgefund

You might be wondering what the differences between prop shops and hedge funds are, and that's understandable. At first glance, the two are very similar. Here's how to differentiate the two from @derivstrading", a retired sales and trading employee.

Prop shops

derivstrading - Sales and Trading:
Prop shops, in general, are smaller and more nimble, and try to extract nickels from all over the place due to inefficiencies. (Some do it with statistical models; some with speed of execution; etc.)

Hedge funds

derivstrading - Sales and Trading:
If you have an HF that has 1bln of capital and they make 20% or 200mln, they get to keep 40mln in performance fees for compensation. For a self-funded prop shop with no outside investors, to get the same comp payout in total for the same 20% return on capital, you would only need 200m of capital. Prop shops tend to be smaller, however, but you can see why payouts can be quite high for them.

A couple of notable differences here, even beyond what @derivstrading" mentions. As mentioned, the fee structure means that, despite prop trading having less capital to work with, they can make similarly large quantities of money as they're mainly dealing with their own capital. So, prop shops have less influence on their trades from outside forces, less overhead, and make as much from less capital. Why, then, do hedge funds get all the buzz? First, prop shops are shrinking and there are fewer desks available due to regulations and decreased risk capacity (more on that later). Second, trading at a hedge fund is far closer to what is traditionally perceived as investing. Prop trading is, as @derivstrading" said, moreso trying to make money through market inefficiencies.

proprietary trader career path

Pursuing a career in trading is a tempting thing out of undergrad: entrepreneurial environment, chance to earn your book after a couple of years, great pay, and more. Compared to the garden variety job out of undergrad, prop trading is a very good job. However, if you're of the caliber that you're looking into prop trading jobs, you should be looking at other top-tier jobs as well. Investment banking has better compensation (albeit worse hours) and far better career versatility. Once you've paid your dues in IB, you can do pretty much anything. Private equity, top MBA, hedge fund, corporate development, you name it and it's probably a viable exit opportunity. Exit opps out of a prop shop are almost entirely other trading gigs or business school.

The main issue is if you don't succeed as trader. In that case, you're stuck trying to justify that failure to whatever business schools you apply to and whatever firms you try to lateral into.

Ultimately, if trading is your endgame, then opting for prop trading immediately out of undergrad is still a good choice. To forego better and more conservative options like investment banking, you need to be passionate towards trading.

That being said here is a more "traditional" route to the trading desk.

derivstrading - Sales and Trading:
If you get into one of the top prop firms - there is no exit opportunity because if you are any good they will give you a hedge fund. Why not let them raise the money for you? Striking out on your own to get that extra 10-20% is kind of absurd when you think of the costs of running a bd and all of the regulatory crap that goes along with it. Here are the steps:
  1. Excellent Academic Record
  2. Relevant Internships
  3. Assistant Trader
  4. Trader
  5. Hedge Fund/Prop Trader

If you have an opportunity with one of the top shops...I would suggest that you take it.

Related Terms

Return to Finance Dictionary

Prop Trading Interview Course

Start Discussion

Total Avg Compensation

April 2021 Investment Banking

  • Director/MD (9) $911
  • Vice President (33) $350
  • Associates (181) $232
  • 2nd Year Analyst (103) $151
  • Intern/Summer Associate (95) $145
  • 3rd+ Year Analyst (26) $145
  • 1st Year Analyst (388) $131
  • Intern/Summer Analyst (317) $82