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The global financial markets are built on the bedrock of liquidity. Without sufficient liquidity, markets would not be able to function efficiently and trading would be far riskier than it is today. There are different types of participants present on the market at any given time and their activity ensures a liquid and efficient market.
For example, principal traders, who we often know as broker-dealers, use their company’s own capital to time their trades and profit from the spread they get from their transactions. If a principal trader buys a certain stock and sells it on to clients at a slim markup, the spread is their profit from the trade. A principal trader takes on the risk of holding assets in their own inventory. On the other hand, proprietary traders, also called prop traders, tend to have funded accounts that are designated to them, and their sole goal is to generate as high returns on their capital as possible.
Prop traders may use a variety of complex trading strategies to achieve their goals, such as quantitative trading, HFT, options trading, etc.
While the distinction between the two may seem slim, principal and proprietary trading are two different approaches to trading. If you are curious about what these differences entail - this investfox guide is for you.
"I have done an awful lot of training at both levels [individual and institutional] and quite honestly there is not a great deal of difference" - David Paul
Principal trading works in a fairly straightforward fashion. A financial institution, such as a broker or a bank, buys and sells securities using its own funds and not on behalf of its clients. Therefore, the institution is the one that bears the risks and benefits associated with holding these assets. Once the price of the assets reaches a desired level, the institution then sells them for a profit. Principal trades may be characterized by high volumes, such as those done by banks and brokers with billions of dollars in expendable capital, who typically hold large positions for substantial profits.
"I think just don't try and compete with the big money machine, the funds, the hedge funds, the professional traders, the institutional traders.. these people have got microsecond low latency connectivity
they, definitely know the news before you do.. they've already priced it in they've already made their money and so you can't compete with that. So just avoid trying to compete with the thing, the areas in which you've got no chance of doing better than them. There are areas where they actually have no advantage over you and why not go for that.. where you're really on a level playing field with them" - Trevor Neil
Essentially, financial institutions engaged in the principal trading act as market makers and enhance liquidity for every other market participant. Institutions may resort to principal trading to trade a broad range of securities, such as stocks and CFDs, Forex, commodities, etc.
Similarly to principal trading, proprietary, or prop trading, involves financial institutions using their own capital to buy and sell securities on the market. Typically, the trading teams of the institution are assigned a capital budget they can use to identify favorable short-term speculative trades on the market and make the most of them using a variety of complex trading tools. Often, prop trading involves the use of high-frequency algorithmic trading with limited human input.
The primary focus of proprietary trading is to take advantage of short-term fluctuations in the market to generate profits, as opposed to the market-making capabilities of principal trading.
Institutions use a number of different metrics to evaluate their proprietary trades, such as risk/reward ratios and risk-adjusted return on capital, or RAROC.
Now that we have covered principal and proprietary trading individually, we can identify the key similarities and differences between the two methods of trading used by financial institutions.
Principal trading is a market-making activity that creates liquidity on the market and generates profits based on spread, while proprietary trading is speculative and depends on market movements for profit.
Proprietary, or prop trading, is a market activity that is done using the corporate funds of a financial institution in order to generate profits through short-term speculative trading. Proprietary trading can be done using a broad range of securities, such as stocks, options, CFDs, Forex, cryptocurrencies, etc.
Principal trading is generally regarded as safer and more predictable than prop trading, as it creates liquidity on the market and profits from spreads, while prop trading is subject to a lot of market risk and returns depend on market movements, which can be volatile.