Over the past few years, proprietary trading has exploded in popularity, even relative to a surge of interest in retail investing and trading as a whole.
Whilst not entirely connected to computer trading, dedicated technology and the rise of independent trading firms, proprietary trading in the form we recognise today began to take shape because of the evolution of financial markets outside of physical trading floors.
However, understanding the underlying systems that make it work is only part of the puzzle of understanding why financial firms are opting for proprietary trading in significant numbers, with the bigger question being about how these firms make their money in the first place.
There is a somewhat simple answer that explains how prop trading conceptually makes money, as well as a more detailed description of how prop firm companies that have launched in recent years make their returns.
How Does Prop Trading Make Money?
Traditionally, investment firms worked by taking money from financial clients, investing it on their behalf and at least partially under their direction, and claiming an agreed commission percentage.
This commission tends to be relatively small in terms of proportion, which means that the best ways to make money as an investment firm are to either take on clients with huge portfolios and make large commissions in real terms, or take on a lot of clients and make money through an investment version of the long tail.
Alternatively, some investment firms earned higher commissions on the basis of increased trust but the best way to make a greater proportion of returns was to opt for a proprietary trading approach.
At its core, prop trading simply means that a firm uses its own capital to invest, which means that whilst it assumes all of the risks for any trades that happen to go wrong, it also claims all of the profits for itself, discounting fees, interest and any other charges that come as a result of their trading strategy.
This is often the reason why a lot of very successful traders move into prop trading; rather than being told how to invest and making a relatively small amount of the money they earned, a trader could instead invest their own money however they chose, and reap the rewards.
In a macro sense, this is how prop trading firms also make money, regardless of scale. They use their own money or money they have access to through various types of investment or loan arrangements, and use whichever trading strategies they want to make their profit.
They can follow their own investment spheres of interests, ethical rules, and choose to work with people they trust to have their best interests at heart.
However, whilst this is the simplest explanation for prop firms, it is not the only tactic that prop firms use to make money.
How Do Prop Firms Make Money?
The majority of modern prop firms operate almost as an inverse of the traditional investment bank; rather than clients giving money to a firm for them to invest and make returns on, prop firms offer access to their capital to skilled investors who prove themselves, and split the profits.
It is an appealing prospect, especially for certain types of trading strategies or markets that are difficult or impossible to undertake with the levels of capital most retail traders have access to.
Whether it is new traders looking for a way in or financial experts exploring a way to put their knowledge into practice outside of a huge firm or going it alone, prop firms have a considerable appeal to them and the potential for both parties to make a lot of money together.
However, this evaluation process itself has become a source of revenue for many prop firms.
Almost every modern prop firm has some kind of challenge system, usually taking the form of a membership scheme, multi-step evaluation process or challenge that a trader needs to complete before they are given access to an account.
This almost always requires a membership fee, one that either is never given back to the trader or is only given back once they succeed.
This means that every single time a trader tries to join a new prop firm, not only do they have the potential to make the firm money through a revenue split, but they typically make money immediately through their application fee, which increases depending on the level of capital in the account they want.
Successful traders, outside of profit-sharing, also provide revenue in other ways; they act as a billboard of success for the firm, showing that it can work for traders who have the right skills and mindset, as well as sometimes generating revenue through commission fees depending on how the firm operates.
Many prop firms offer educational resources, some of which could also be revenue-generating vehicles.
Finally, there are partnerships and sponsorships with trading platforms and tools, and adding them to the platform could also generate additional revenue.
