Proprietary Trading

What Is Proprietary Trading?

Proprietary trading, often called "prop trading," is when a firm buys and sells financial instruments such as stocks, bonds, currencies, commodities and derivatives using its own capital instead of money belonging to clients. The firm keeps the profits from these trades and bears the losses. Investment banks and specialized trading firms have historically been the main practitioners.

How It Works

Proprietary traders aim to earn returns from price movements, from small pricing gaps between related markets, or from the spread between buy and sell prices. Common approaches include arbitrage, short-term directional bets, and market making.

Because the firm itself takes the risk, it usually sets internal limits on how much capital each trading desk can commit and how large losses can grow before positions are reduced. Many firms also use leverage, which uses borrowed funds to magnify both gains and losses.

An Illustration

Suppose a trading desk notices that two closely related securities are priced slightly apart. It buys the cheaper one and sells the more expensive one, expecting the prices to converge. If they do, the desk profits from the difference. If the prices move further apart first, the firm absorbs the loss, and its internal risk limits determine how far the position can run. This example is hypothetical and shows only the mechanics.

Why It Matters to Investors

Proprietary trading can add market liquidity and help narrow the bid-ask spread, which can benefit other market participants. It can also concentrate risk inside financial institutions. After the 2008 financial crisis, many countries placed restrictions on banks trading with their own capital. In the United States, the Volcker Rule, part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, limits banking entities from proprietary trading, with several exceptions. Investors may find that these rules shape which firms trade in certain markets and how banks manage their balance sheets.