Highlights
- Proprietary trading refers to a term when a commercial bank or a financial firm trades in stocks, bonds, or commodities in its own account.
- The financial entity uses its own money instead of using clients’ money to make direct market gains.
- Such trades conducted by a financial institution, brokerage firm, investment bank, hedge fund or other liquidity source using the firm's capital are generally speculative in nature.
Proprietary trading also known as prop trading refers to a term when a commercial bank or a financial firm trades in stocks, bonds, or commodities in its own account. The financial entity uses its own money instead of using clients’ money to make direct market gains.
The key thought behind the financial firms engaging in proprietary is their belief that they have a competitive advantage to earn an annual return that exceeds index investing, bond yield appreciation or other investment styles.
Such trades conducted by a financial institution, brokerage firm, investment bank, hedge fund or other liquidity source using the firm's capital are generally speculative, executed through a range of derivatives or other complex investment vehicles.
Merger arbitrage, global macro-trading, and index arbitrage to maximise returns are a few strategies used by prop traders. These traders can access sophisticated software to make critical decisions.
Generally, proprietary trading desk is separated from other trading desks in an institution involved in prop trading. It is done for proprietary trading to be effective, while keeping the institution’s clients in mind.
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Advantages of propriety trading
There are several benefits that a financial institution can derive from prop trading including higher quarterly and annual profits. Trading on behalf of clients earns financial institutions just marginal revenues in the form of commissions and fees.
Using proprietary trading, the financial institutions can stockpile an inventory of securities. Institution gets access to provide an unexpected advantage to clients with this speculative inventory. In addition, it helps these institutions prepare for sluggish market conditions when it becomes harder to purchase or sell securities on the open market.
Prop trading also allows the financial institution to become a key market maker by offering liquidity on a specific security or group of securities.
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Bottom Line
Even as proprietary trading is generally seen as risky, it is often one of the most profitable operations for the financial institutions. However, retail investors must know that prop trading doesn’t benefit them as activity does not execute trade on behalf of clients.
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