Proprietary Trading

What is Proprietary Trading?

Proprietary trading, also known as prop trading, is the practice of using a company's own money to execute trades. Rather than using the client's money to make trades and earning revenue based on commission, a company assumes its own position and therefore takes both the profit or loss that results from such a trade. This type of trading is attractive to firms because they can make a much larger profit from the trade than from earning only commissions as they get to keep 100% of the profit.

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Firms that employ prop trading strategies are those that believe they have access to greater volume and quality of information than the rest of the market and therefore are able to make better trading decisions. They also have access to very advanced technology that allows them to trade faster and perform complex analyses of the market.

This strategy is considered very risky because while it is true that a firm may keep the entire profit, it must also absorb any and all losses. For this reason, this strategy has come under a great deal of scrutiny from lawmakers and the public alike. In particular, it was targeted by the Volcker rule, which severely limits the firms' ability to invest their own capital. Since this rule has come into play, many firms have closed their proprietary trading segments or have spun them off from their parent firm. Today, many specialized proprietary trading firms exist and are often called "prop shops".

Prop trading: How does it work?

Prop trading is when traders use a firm's funds to make investments rather than managing clients' money. This allows a bank to keep the entire profit (or loss) from its trades. This practice originated at a time when banks needed to "make the market". This means that banks would hold different types of investments on their own accounts to create more liquidity for their customers.

For example, a bank could hold certain types of rare securities and when their customers decide to buy one, they could act as a seller instead of buying from the open market. The bank can also act as an intermediary buyer for a client if they are trying to sell certain securities for which there are not many buyers in the open market. Eventually, these types of services evolved as traders found better ways to value stocks and play the market. Before long, traders were trading with firm capital for more than just providing liquidity.

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Banks have an advantage over the market because of the amount of information and advanced technology that they have access to. This allows prop traders to create complicated and better computer models that settle trades faster than average traders. The range of information that is available to them also sets them apart from the average trader. This type of trading usually aims to take advantage of price discrepancies in the market to reap a profit from the market correcting to equilibrium.

This method of buying and selling securities that have different prices in different markets in order to generate a profit is described as arbitrage. We look into some of the different types of arbitrage in the section on prop trading strategies below.

There have been increased concerns about prop trading creating a conflict of interest between banks and their customers as well as allegations of insider trading. To address these concerns, banks have started to separate this division from the main operations of the firm, generally by using a Chinese wall

Prop trading strategies

Prop trading usually relies on a strategy called arbitrage. Arbitrage is the buying and selling of assets in different markets in order to take advantage of price discrepancies between them to lock in a profit at no risk. Since it takes advantage of price discrepancies, it also fulfills the process of keeping markets largely at equilibrium.

Firms are able to generate profits on arbitrage trades because of the high-grade technology that enables them to make fast trades and execute complicated algorithms as well as create complex pricing models. Aside from their technological advantage, firms also usually have considerable knowledge of the markets that they are engaging in and can use their wealth of information to their benefit. We take a look at some of the ways prop traders profit below.

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In a strategy called index arbitrage, a firm trades on price discrepancies in different indices. This can be accomplished by trading the components of the indices, or investments that track the index such as Exchange Traded Funds (ETFs). Indices usually only exhibit price differences for very short amounts of time, sometimes only for fractions of a second. For this reason index arbitrage is usually executed by computer programs.

A strategy called merger arbitrage takes advantage of the market fluctuations that occur during a merger or acquisition. Usually, the purchasing company sees a decrease in their share price, and the company being bought sees their share price increase. This occurs because typically the purchasing company buys the other company at a price above its market share price, meaning that the large purchase above market price brings the purchased company's share price higher and the purchasing company's share price lower.

Traders take advantage of this by shorting the purchasing company and investing in the company being purchased to make a profit on both market corrections. This type of arbitrage was a significant concern for insider trading since many firms employing this strategy also tend to assist the same businesses with mergers and acquisitions.

Fundamental analysis is a strategy that seeks to find the true market value of an asset and invest in them when the calculated values are different from their market value. It takes into account many types of information about the asset such as the macro-environment, the industry, related securities, and the micro-environment it is exposed to in order to evaluate the asset's intrinsic value. Fundamental analysis is a fairly common strategy of investment and is in the toolbox of many value investors. 

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The strategy of statistical arbitrage involves creating large and diverse portfolios of many securities and trading them in a very short period of time. This can be done by ranking the securities in the portfolio and organizing the holdings in order to minimize risk in the portfolio. In a specific tactic of statistical arbitrage called pairs trading a firm may purchase related securities, taking a long position in an undervalued asset and a short position in an overvalued asset.

Statistical arbitrage relies heavily on the concept of mean reversion, which is the idea that the markets will return to what is a historically predictable market. While doing any kind of arbitrage, it is important to keep in mind the adage, "the market can stay irrational longer than you can stay solvent." Statistical arbitrage usually relies on large amounts of data and computer modeling to make reliable predictions and profitable trades.

In the strategy known as volatility arbitrage, a trader invests in options and assets to profit from the discrepancy between the forecasted volatility of an asset and the implied volatility of options on the asset. The fundamental calculation in this type of arbitrage involves estimating whether the implied volatility is overvalued or undervalued in an option compared to that of the underlying asset.

Another strategy is technical analysis. Not to be confused with fundamental analysis, a technical analyst makes speculations based on the price and volume of a security rather than the underlying financials of a company and macroeconomic factors. Technical analysts believe that historical price movements and patterns and changes in volume and price can predict future price actions. In this sense, technical analysis can be similar to statistical arbitrage. This type of analysis has more recently surged in popularity due to the entry of a large number of retail investors in the general market.

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Forex arbitrage is a type of trading that aims to take advantage of price discrepancies of currencies in different exchange rates. Because of the sheer volume of trading in forex markets, these discrepancies are very small and usually do not last long. Opportunities to profit based on these discrepancies usually exist within a very narrow window of time.

The various strategies described above are employed across all types of trading and a firm may pick any one or a combination of strategies depending on the skills of its traders. Generally, prop trading firms rely on arbitrage and technical analysis to make a profit and take advantage of their competitive edge in informational and technological resources.

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