Many investors believe that the majority of stock exchange trading volume comes from individual retail investors. This is not true. There are many institutions, companies, and corporations that participate in stock market activities.
Even stockbroking firms with investors who have trading accounts are more likely to trade in the stockmarket and invest regularly. This is known as proprietary trading. You want to learn more about proprietary trading? Continue reading to learn more about this unique concept.
The activity of proprietary trading is when a financial service firm, such as a brokerage house, investment bank, hedge fund or commercial bank, engages in trading and investing in the stock exchange. This type of activity is also known as "prop trading" by stock market pundits. You should know that the funds these firms use to trade or invest in the stock exchange are theirs and not their clients.
After answering the question "What is proprietary trading?" let's now turn our attention to understanding why these institutions and firms engage in trading activities.
This question has an easy answer. Prop trading is a business activity that financial institutions engage in for their own corporate benefit. Because of the fierce competition they face, financial institutions and stock brokerage houses operate with razor-thin margins when it comes to their products and services. Their primary business revenue may not be sufficient to sustain them long-term. They then resort to proprietary trading in order to make a profit trading and investing in stock markets. The company would use the revenue from the stock market to support its business and achieve its goals.
Second, corporations and firms in the financial sector tend to have a greater competitive advantage than the retail investor segment. They have access to more price-sensitive, high-level information and can use it to their advantage. Financial institutions can enjoy a higher rate than investing in bonds or term deposits by using proprietary trading.
Although financial firms are involved in the equity segment, they are primarily focused on derivatives like futures and options. The fact that almost all of these trades are speculative is one of the main reasons for increased trading activity in futures and options. Proprietary traders use a combination of different trading strategies, including technical analysis and fundamental analysis.
Are there any other benefits to proprietary trading?
Technically, proprietary traders are an advantage to market participants. They are backed by large investment capital funds, so they can easily make large trades. This allows investors to easily buy and sell securities, as it infuses large amounts liquidity into the counter. Prop trading also allows the trading company to become a market maker and has some influence on the markets.
A major advantage of proprietary trading is the ability to store the shares of companies as inventory. Firms can then sell the stocks to clients who want them and make a profit.
Prop trading is done by the firms themselves, which allows them to take on more risk because they are not accountable to their clients. Each profit and loss they make must be paid by the entity. Prop trading firms make use of sophisticated and proprietary trading software that isn't available to the public. They also use automated and algorithmic trading platforms for high-frequency trading. This gives them an advantage over regular retail traders or investors.