Benefits and Risks Involved in Proprietary Trading

Proprietary trading provides many benefits to a financial institution or commercial bank, most notably higher quarterly and annual profits.

Fremont, CA: Rather than trading on behalf of clients to earn commission dollars, private trading refers to investments made by a financial firm or commercial bank.

 A proprietary trader may trade stocks, bonds, commodities, currencies or other instruments. In proprietary trading, financial firms or commercial banks believe they will be able to earn a higher return than index investing, bond yield appreciation, or other investing methods.

How Does Proprietary Trading Work?

In proprietary trading, also known as "prop trading," a trading desk at a financial institution, brokerage firm, investment bank, hedge fund or other liquidity source promotes its own business using the firm's capital and balance sheet. A variety of derivatives and other complex investment vehicles are used in these trades, which are usually speculative in nature.

● Market strategies used by proprietary traders include index arbitrage, statistical arbitrage, merger arbitrage, fundamental analysis, volatility arbitrage, technical analysis, and global macro trading.

● In order to obscure activities that promote corporate self-interest, large financial institutions purposefully obfuscate details on proprietary vs. nonproprietary trading operations.

 Benefits of Proprietary Trading

Proprietary trading provides many benefits to a financial institution or commercial bank, most notably higher quarterly and annual profits. Trading on behalf of clients generates commissions and fees for brokerage firms and investment banks. While this income can represent a very small percentage of the total amount invested or gains generated, the process also allows an institution to realize 100 percent of its gains.

Secondly, the institution is able to stockpile securities. There are two ways in which this helps. In the first place, any speculative inventory gives the institution an unexpected advantage over its clients. Second, it prepares these institutions for market downturns or illiquidity’s when securities on the open market become more difficult to acquire or sell.

Associated with the second benefit is the final benefit. Financial institutions can become influential market makers by providing liquidity for specific securities or groups of securities through proprietary trading.

An Example of a Proprietary Trading Desk

Normally, proprietary trading desks are "roped off" from other trading desks in order to maximize their effectiveness and serve the institution's clients. Despite acting autonomously, this desk is responsible for a portion of the financial institution's revenues.

Market makers, however, can also be proprietary trading desks. Client may find themselves in this situation when he or she wants to trade large amounts of a single security or a highly illiquid security. This type of trade has few buyers or sellers, so a proprietary trading desk acts as buyer or seller, initiating the other side of the trade.