Proprietary trading (prop trading) is when a financial firm trades stocks, bonds, currencies, commodities, derivatives or other instruments with its own money instead of its clients’ money, and keeps the profits or absorbs the losses itself. A bank or broker that executes client orders earns commissions and fees. A prop desk earns, or loses, whatever its positions return. The same term now also covers a newer, retail-facing business: “prop firms” that let individual traders trade firm capital after passing an evaluation. Both models share the core idea of trading the firm’s capital, but they work very differently.
How proprietary trading works
At an institution, proprietary trading happens on a dedicated desk that uses the firm’s capital and balance sheet. That desk might sit inside an investment bank, a brokerage, a hedge fund or a standalone trading firm. Its trades are usually speculative: the desk takes a position because it expects to profit, not because a client asked for it. Positions are often built with derivatives or other complex instruments, which lets the desk control large exposures with less upfront capital and also magnifies losses.
Firms that run prop desks believe they have an edge, whether that is better information flow, faster execution, superior models or simply cheaper funding. The aim is to earn a return above what the same capital would make in an index fund, in bonds or through other passive approaches.
Common prop trading strategies
- Index arbitrage: exploiting price gaps between a stock index future and the basket of stocks it tracks.
- Statistical arbitrage: using quantitative models to trade many securities whose prices historically move together, betting that temporary divergences will close.
- Merger arbitrage: buying the target of an announced acquisition (and sometimes shorting the acquirer) to capture the spread that remains until the deal closes.
- Volatility arbitrage: trading the difference between the volatility implied by option prices and the volatility the trader expects to occur.
- Global macro: taking positions in currencies, rates, commodities or indexes based on views about economies and policy.
- Fundamental and technical analysis: using company financials or price and volume patterns to choose directional trades.
Why firms trade their own capital
The main reason is profit. When a broker trades for a client, the firm’s revenue is a commission or fee that is often a small fraction of the amount traded. When the firm trades its own account, it keeps 100% of any gain. A single successful position can produce more revenue than a large volume of client business.
Prop trading also gives the firm an inventory of securities. Holding inventory helps in two ways. The firm can offer clients securities or prices they could not easily get elsewhere, and it is better prepared for falling or illiquid markets, when buying or selling in the open market becomes difficult.
That inventory supports a third role: market making. By standing ready to buy and sell a particular security or group of securities, the firm provides liquidity and earns the bid/ask spread. Firms take on these risks because there is no client to answer to. A prop desk can run a level of risk that would be unacceptable in a client’s account, within limits set by the firm’s own risk managers and regulators.
Example of a proprietary trading desk
To protect clients, a prop desk is normally walled off (“roped off”) from the desks that handle client orders and works autonomously on revenue unrelated to client work. The separation is meant to stop the desk from trading ahead of client orders or using confidential client information.
Prop desks can still interact with clients through market making. In a hypothetical case, an asset manager wants to sell a very large block of a thinly traded corporate bond. Few buyers exist at that size, so selling into the open market would push the price down sharply. The bank’s prop desk can buy the entire block at an agreed price, then hold it or sell it gradually over the following days or weeks. The client gets immediate execution; the desk takes the risk that the bond falls before it can be resold, in exchange for buying at a discount.
Risks and conflicts of interest
Prop trading concentrates risk on the firm’s balance sheet. Leveraged positions in derivatives can lose far more than expected when markets move sharply or liquidity disappears, and losses at a bank can spill over to depositors, counterparties and the wider financial system.
There is also a conflict of interest whenever the same institution trades for itself and for clients. Even with information barriers, critics argue that large institutions are not always transparent about which activity is proprietary and which is client-driven, which makes it harder for outsiders to judge whose interests a trade serves. This concern, combined with large trading losses during the 2007 to 2008 financial crisis, shaped the rules that now limit prop trading at banks.
Can banks engage in proprietary trading?
In the United States, largely no, with important exceptions. The Volcker Rule, part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and named after former Federal Reserve Chair Paul Volcker, restricts banking entities from short-term proprietary trading in securities, derivatives, commodity futures and options on those instruments. It also limits banks’ ownership of, and relationships with, hedge funds and private equity funds. The goal is to keep banks that benefit from deposit insurance and central bank access from making the kind of speculative bets that contributed to the Great Recession.
The rule carves out activities that look similar to prop trading but serve clients or manage risk, including:
- market making to meet client demand,
- underwriting new securities,
- hedging specific risks the bank already holds,
- trading in US government securities.
After the rule took effect, large US banks wound down or spun off their dedicated prop desks, and much of that activity moved to hedge funds and independent trading firms, which are not subject to the Volcker ban. The rule applies to US banking entities, so the treatment of prop trading by banks elsewhere depends on local regulation.
Retail prop firms: a different model
A retail prop firm offers individuals a funded trading account rather than running an internal trading desk. The firm supplies the trading capital, or a simulated account that mirrors it; the trader supplies the strategy; and profits are split under the firm’s rules. Some firms pay out based on simulated performance, while others route trades to live markets.
The business model also differs from a bank desk. An institutional prop trader is typically an employee or partner trading firm money on firm systems. A retail prop trader is usually an independent individual who pays a fee to qualify and works under a contract, not as an employee.
How a retail prop firm works, step by step
- Choose a program and account size. Firms offer different account sizes, market types (forex, futures, indexes, crypto) and evaluation formats.
- Pay the evaluation fee. This is a one-time or recurring charge to attempt the challenge; it is not a deposit into the trading account.
- Pass the evaluation. The trader must hit a profit target without breaching loss limits, sometimes over one stage and sometimes over two or more.
- Trade the funded account. The same or similar risk rules continue to apply after funding, and a breach usually ends the account.
- Request payouts. Profits are split between trader and firm according to the program’s profit share, subject to payout schedules and any minimum trading or consistency requirements.
The rules that decide whether you keep the account
Retail prop trading is governed mainly by risk rules. The most common are:
- Daily loss limit: the most the account may lose in one trading day.
- Maximum drawdown: the most the account may fall from its starting balance (static) or from its highest point (trailing).
- Profit target: the gain required to pass an evaluation stage.
- Minimum trading days, consistency rules and restrictions on news trading, holding over weekends or certain strategies.
The detail that catches many traders is whether a limit is measured on balance (closed trades only) or equity (including open profit and loss). In a hypothetical $100,000 account with a 5% daily loss limit calculated from the day’s starting balance, the account can fall to $95,000 that day. With $3,000 in closed losses and an open position down $2,100, equity is $94,900: an equity-based rule is breached even though the balance still shows $97,000. If drawdown trails the highest equity reached, open profits that are later given back also tighten the room left to trade.
Because these definitions vary by firm and by program, they matter as much as the profit split.
Choosing a prop firm
When comparing firms, look at the evaluation cost relative to account size, how drawdown is calculated, the profit split and payout frequency, which instruments and platforms are offered, and any strategy restrictions. A comparison of prop trading firms sets these terms side by side.
FAQ
Does Goldman Sachs still do proprietary trading?
Not through a dedicated short-term prop desk of the kind it ran before Dodd-Frank. It still trades as a market maker, underwriter and hedger under the Volcker Rule's exemptions.
How do prop traders get paid?
Institutional prop traders typically earn a salary plus a bonus tied to the profits they generate. Retail prop traders receive their profit share from the funded account and bear the cost of the evaluation fee whether or not they pass.
