Prop Firms Vs. Market Making: The Key Differences

If you have been researching trading, you have probably heard of “prop trading firms” and “market making.” 

Even though they are both very important to the financial markets, they function differently and have different goals. 

We’ll compare the characteristics, tactics, and operations of market-making and prop trading companies in this comprehensive guide to help you grasp the main distinctions and make wise trading selections.

What Is Proprietary Trading (Prop Trading)?

Using a company’s funds to trade financial products including stocks, bonds, currencies, and cryptocurrencies to make money is known as proprietary trading or prop trading. 

Essentially, prop trading companies do not execute trades on themselves; instead, they use their capital to participate in the financial markets by giving funded trading accounts to experienced and tested traders to trade on their behalf. 

Prop traders use the firm’s trading platforms, resources, and their unique trading strategies to make transactions. 

Typically, prop traders work for prop trading firms.

Key Aspects Of Prop Trading

There a 3 key differences:

Use of Firm Capital: 

To finance trading operations, prop trading companies take money out of their own pockets to fund traders. 

Prop trading is differentiated from typical retail trading by this, as individual traders use their own money.

Proprietary Trading methods: 

Directional trading, arbitrage, market-making, algorithmic trading, and quantitative trading are just a few of the trading methods used by prop traders. 

These tactics are frequently created internally and are designed to take advantage of price fluctuations and market inefficiencies.

Risk and Reward Sharing: 

The gains made by prop traders are divided between them and the company.

The division of profits is decided by profit-sharing agreements between traders and the firm; traders normally receive a portion of the profits they make.

The upside of this however is that the losses made on the live account are borne by the prop firms and not by the traders. 

This means if a trader loses an account due to multiple losses, he or she does not have to pay the firm any money to make up for the losses incurred.

What Is Market Making?

Market making is a trading method wherein buy and sell prices for a certain asset are regularly quoted.

The goal of this approach is to facilitate trade and provide liquidity to the market. 

Market makers, sometimes referred to as liquidity providers, guarantee that there is a ready market for assets by being prepared to purchase and sell securities at quoted prices. 

The difference between the asking and bidding prices for an item is known as the bid-ask spread, and it is this spread that makes market makers money.

Market makers are usually brokerage houses that offer investors trading services to maintain the liquidity of the financial markets. 

An individual trader, usually referred to as a local, can also function as a market maker.

Because of the magnitude of securities required to support the volume of purchases and sells, the great majority of market makers operate for huge institutions.

Every market maker shows bids and offers for a predetermined quantity of shares.

The market maker promptly sells off their position of shares from their inventory as soon as they receive an order from a buyer.

They can finish the order as a result.

Key Aspects Of Market Making

1. Providing Liquidity: 

By offering to buy and sell securities at specified prices, market makers play a critical role in supplying liquidity to the financial markets. 

This makes it possible for transactions to be completed swiftly and effectively between buyers and sellers without having a big effect on the market price.

2. Capturing the Spread: 

The difference between the prices at which market makers purchase and sell securities is known as the bid-ask spread, and it is this gap that gives them profits. 

Their goal is to purchase assets at a discount and resell them for a profit by keeping the difference between the two prices.

3. Managing Inventory and Risk: 

To balance supply and demand and reduce exposure to market risk, market makers must efficiently manage their inventory of securities. 

They might dynamically modify their price and quotation tactics in response to shifts in the order flow and state of the market.

Market making plays a crucial role in preserving market liquidity and promoting effective price discovery in a variety of financial markets, such as foreign exchange (forex), stocks, options, and futures.

Key Differences Between Prop Firms And Market-Making

 

NOs		Prop Trading Firms	Market Making
1	Purpose	Profits are the main goal of prop trading companies, who use their capital to trade financial products.  To take advantage of market opportunities, they use a variety of trading tactics, such as algorithmic trading, arbitrage, and directed trading.	Conversely, market makers ensure orderly price discovery and supply liquidity, which helps to enable trading in financial markets.  Their main goal is to reduce their exposure to market risk and profit from the bid-ask spread.
2	Capital and Risk	Prop trading companies trade with their own money and take all trading risks.  Prop firm traders run the risk of losing money even if they might get paid a portion of the gains they make.	Compared to prop trading firms, market makers usually have a lower capital base and concentrate on managing inventory and liquidity risk.  To reduce losses, they try to keep their positions in check and hedge their exposure to changes in the market.
3	Trading Strategies	Prop trading companies use a wide variety of trading techniques, such as statistical arbitrage, high-frequency trading, market-neutral tactics, and directed trading.  These businesses modify their tactics in response to shifting market dynamics and try to take advantage of market inefficiencies.	Market makers concentrate on regulating order flow and supplying liquidity as their primary market-neutral techniques.  They might dynamically modify their price and quotation tactics in response to shifts in the order flow and state of the market.
4	Trading Frequency and Holding Periods	Prop trading companies frequently engage in high-frequency trading, which involves placing numerous transactions quickly to profit from little price fluctuations.  Prop firm traders may hold positions for a few seconds, minutes, or even hours, contingent upon their trading tactics and the state of the market.	Market makers, on the other hand, retain positions to profit on the bid-ask spread for comparatively short times, usually seconds or minutes.  To preserve liquidity and control inventory, they constantly modify their quotes and positions; nevertheless, they rarely hold onto positions for more than a few hours at a time.
5	Capital Allocation and Leverage	Prop trading companies distribute capital to individual traders according to their track record, approach to trading, and capacity for risk management.  Leverage offered by the company to traders may enable them to increase their trading positions and possible profits.  Leverage, however, significantly raises the possibility of losses, thus traders need to follow tight risk control procedures.	Market makers set aside money to keep things in stock and make trading in particular assets or markets easier.  They may not employ leverage very often, if at all because their main priorities are supplying liquidity and controlling inventory risk.  In contrast to prop trading businesses, market makers often place a higher priority on capital protection and may keep relatively low leverage levels.
6	Profit Structure and Revenue Sources	Prop trading firms get their money mostly from trading operations, such as charging traders performance fees and capital gains from profitable transactions.  The distribution of profits is decided by profit-sharing agreements between traders and the company; traders typically receive a portion of the profits they make.	The difference between the buying and selling prices of the assets they trade, or the bid-ask spread, is how market makers make money.  By purchasing goods at a discount and reselling them at a premium, they effectively function as middlemen between buyers and sellers, capturing this differential. Exchange fees, order flow rebates, and other market-making incentives provided by trading venues are additional sources of income for market makers.

Conclusion

In conclusion, market-making and prop trading companies both have significant roles in the financial markets, but they have different goals, approaches, and risk tolerances. 

Market makers give liquidity and ease trade by providing prices for financial assets, while prop trading businesses concentrate on making money through active trading and speculation. 

Traders and investors can make better decisions and negotiate the intricacies of the financial markets by being aware of the differences between these two organizations.