Proprietary trading

Proprietary trading also called prop’ trading is performed by professional traders in investment banks. Proprietary trading is linked with the traders’ role of market making.

Market making is the task of making markets for clients willing to buy or sell financial assets. This is performed by professional traders by taking the other side of clients to generate trading commissions. However, to generate business and make commissions, professional traders often take financial positions which are loss generating and undesirable.

Example: A client is willing to buy $1 million of Microsoft stock at $187 and the current price of Microsoft is $187.5. He calls a trader in an investment bank and makes a bid for $1 million of Microsoft stocks at $187. Since the trader is willing to keep the client and generate commissions, he is willing to offer stock for $187 incurring immediately a potential financial loss of $5,300 ($1 million x ($187-$187.5/$187.5).

The professional trader’s second role then is to use the investment bank’s balance sheet to make back more than the money lost in making markets for the clients. This is called proprietary trading.

Proprietary trading is the management of an investment portfolio. The investment portfolio consists of long positions the trader believes will outperform the market and short positions the trader believes will fall in price or underperform the long positions of the portfolio. The aim of a professional trader is to earn the best risk-adjusted return on capital possible.

Explore our guide on portfolio management created by our team of professional fund managers.