Prop Trading Vs Institutional Trading

Key Highlights

Institutional trading and prop trading share one similarity: both involve high-volume trading using large capital allocations. But this is where their similarities end and their differences begin. These forms of trading differ fundamentally in terms of regulatory oversight, long-term objectives, and source of funds.

In a nutshell:

• Proprietary (prop) trading focuses on pure profit and often relies on the use of high-risk speculative trading strategies. Today, remote traders can get funded after passing an evaluation phase. 
• Institutional trading focuses on hedging, liquidity provision, and managing client portfolios. Examples of entities involved in this line of trading include banks and hedge funds. 
• The Volker Rule: Banks in the U.S are restricted by the U.S. Dodd-Frank legislation with regard to how they can use their own funds to engage in speculative trading activities. 

Prop Trading Vs Institutional Trading

Institutional traders are professionals responsible for trading large volumes on behalf of organizations like pension funds, hedge funds, and commercial banks. Prop traders, on the other hand, are traders who use a prop firm’s money, tools, and resources to trade, in exchange for a profit split.

The main difference between the two is how capital is used, institutions use pooled funds while prop traders use firm-provided capital. And while the advances happening in the tech sector have helped reduce the differences between these two, glaring differences still exist.

In this guide, we are going to take you through the role, capital sources, risk profile, autonomy and key differences between these two types of traders to help you understand the differences. Read on to learn more about the process of comparing prop trading firms.

Understanding Institutional Traders and the Advantage They Hold

An institutional trader is a professional trader who trades large volumes of stocks, bonds, and derivatives on behalf of clients such as banks and pension funds. Their characteristics are as follows:

• Role: The trader works for a financial institution such as an asset management firm. Their responsibility is to invest and manage client funds.
• Risk Profile: Institutional traders are tasked with managing risk and attaining the investment objectives set by their clients or employers. Their compensation package includes a salary and a bonus.
• Source of Investment Capital: These professional traders operate using the funds managed by their employer. Please note that they don’t trade with the firm’s capital.
• Regulatory Oversight: Institutional traders are required to operate within a predefined framework. All their activities are subject to evaluation for compliance. 

A close analysis of the trading space reveals that institutional traders have the added advantage of being able to invest in securities that prop traders ordinarily don't have access to. Examples of such include swaps and forwards.

Further research into why prop traders aren’t allowed to trade these securities shows that this is because of the complex nature and transactions involved in these securities. It’s also the reason why you’ll find institutional traders being solicited to invest in IPOs, while prop traders are left out.

While trying to understand how institutional traders work, you’ll learn that, due to the high volume nature of their trades, any actions taken by an institutional trader can significantly impact market prices. To prevent this from happening, they occasionally have to split their trades over time or among numerous brokers.

 It’s important to note that a single institutional trader will typically trade a block having at least 10,000 shares. The trader can minimize their operational costs by sending such trades to an exchange via an intermediary or independently.

Key Characteristics of a Prop Firm Trader

A prop trader is an individual who uses a bank or investment firm’s own money to trade financial instruments such as stocks, commodities, currencies, or bonds. The trader gets to keep a percentage of the profits they generate, allowing them to trade larger positions without using their own money

Their characteristics are as below:

• Role: Prop traders partner with prop trading firms in an agreement that sees both parties sharing the profits and losses. 
• Risk Profile: The prop firm will enforce certain rules, e.g., daily and maximum loss limits to protect its capital and prevent gambling-like behavior among its traders. 
• Source of Capital: The capital they use is provided by prop trading firms. A trader must first prove that they can manage risk and remain consistently profitable to access this kind of capital.
• Autonomy: Prop traders have more leeway when it comes to decision-making compared to institutional traders. The trader will often have specific markets to focus on. 

Prop trading is recommended for experienced traders seeking high capital access to place larger trades without risking their own finances. Such a partnership can benefit them immensely, especially if they’re capable of managing strict risk parameters. 

Prop Trading vs Institutional Trading: Key Differences Explained

Prop trading and institutional trading primarily differ when it comes to the source of capital and the long-term objectives. Institutional trading, for one, involves managing pooled funds from mutual funds and pension funds. Prop trading, on the other hand, involves using the prop trading company’s capital.

Here are the key differences:

• Compensation Structure: Prop traders are compensated based on their trading performance, consistency, and the profits they have generated. Institutional traders get compensated using a more traditional approach where they earn a monthly salary and a bonus tied to their performance.
• Autonomy: Traders working with a prop firm will have more freedom when it comes to decision-making. For institutional traders, they have no option but to adhere to the investment guidelines and strategies provided by the fund or institution that they work for. 
• Source of Financing and Nature of Risk Involved: Prop traders operate using accounts funded by the prop trading company, while their counterparts manage external funds pooled from pension funds and other clients. 

The following table helps provide a side-by-side comparison of these differences. 

Conclusion

Prop traders use firm capital to buy and sell securities to make direct profits for the firm and for themselves. In contrast, institutional traders engage in high-volume trading for organizations such as pension funds that have entrusted them with their own money. The large nature of trades undertaken by institutional traders enables them to negotiate for better terms, something that prop traders can’t do. 

And while advancements in the tech sector are helping to narrow the gap between institutions and prop firms, the former still has an advantage in the security products they can trade, their position sizing, and the prices they can buy these products at. 

At Audacity Capital, we will provide you with the resources, tools, and technology that you need to become a profitable prop trader. Check to learn about how our funded trader program works and the benefits it offers. 

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