Prop trading is an interesting facet that many major financial institutions incorporate into their wider approach for increased revenue. It gives a financial institution more diversity outside of raking in commissions from their clientele. Let’s take a basic look at what prop trading actually means and how it works.
Understanding Prop Trading
Proprietary trading, or prop trading, is essentially when financial institutions like banks, brokerage firms or investment banks directly invest in the stock market. Much like an individual investor might do, these financial institutions will trade or invest in stocks, bonds, commodities, derivatives, futures, etc.
However, the key factor to understand here is that these financial institutions are using their own capital to invest or trade in the stock market and not their clients’ funds. Many of these financial institutions seek to make increased profit from their own trades, as well as from the commissions they receive from their clientele.
Pros and Cons of Prop Trading
There are a number of variables when it comes to prop trading, some of which serve as real advantages and others that are less likely to favor a financial institution. Let’s take a brief look at some of the pros and cons of prop trading.
The most obvious pro for prop trading is the increase in profits. A financial institution does not need to rest on its haunches by only earning profits from client commissions. By prop trading, they can greatly increase the overall revenue of the firm/company/bank.
Prop trading firms will typically have better access to leverage. Leverage limits are generally not strictly enforced when it comes to prop trading firms which means you can have several open positions that are trading on margin.
Prop trading firms provide higher liquidity. As these firms allow far more open trading positions, they become a much better option than a retail client. Prop trading firms can allow you to have hundreds of open positions at once.
Prop trading firms almost always offer rebates. A rebate is simply compensation for adding liquidity to a market. As a retail client, you are unlikely to receive rebates like this other than with a prop trading firm.
It’s important to note that prop trading firms are not as well regulated as your typical brokerage firm. Many prop trading firms are not regulated at all, which means that there is a risk of you losing your capital investment to swindlers. It’s crucial that you do your own research on these firms before using them to make sure that they are operating with a certain degree of integrity.
Prop trading firms have higher than average trading fees. These firms will charge you for the software that you are making use of. These fees can be anywhere from upwards of $200 a month. If you take the time to compare this to standard brokerage firms, you’ll find the disparity between the two to be fairly big.
Prop trading can be fairly one dimensional as they are almost always only used for day trading. You’ll have access to leverage for day trading but should you want to hold a position over night, your leverage will decrease significantly.
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