What Is a Prop Shop?
A prop shop is a trading firm that deploys its own capital in pursuit of trading profits. 'Prop' is short for proprietary. A variety of trading strategies are employed by prop shops for assets ranging from basic liquid assets like stocks and bonds to complex securities such as collateralized debt obligations (CDO), derivatives, and commodity futures. They also are active in arbitrage strategies and large macro bets. Prop shops can go long, go short, or do both. Buys and sells are typically executed by traders, but algorithmic trading is important for a growing number of prop shops.
Understanding Prop Shop
Prop shops are formed by individuals who contribute their own capital. If these owners want to run a tight ship, they will conduct the trading themselves. If they wish to scale up, the prop shop founders will employ traders to carry out designated strategies or set them loose to freely trade on their own. Anyone taken aboard must contribute their own capital as an entry fee, and will be subject to trading risk limits. A prop shop splits trading profits, if any, between the firm and the trader. Prop shop trading is high risk, high reward. A trader can strike gold one day, give it all back the next, become wealthy beyond their dreams within months if good or lucky, or implode entirely and end up being escorted out of the building carrying a cardboard box and grim expression.
Prop Shop vs. Prop Desk
Until the enactment of the Volcker Rule, proprietary trading desks could be found at investment banks playing with big chunks of bank capital. Sometimes these prop desks earned disproportionate amounts of profits for their hosts and sometimes they fared poorly. For example, Morgan Stanley's prop desk lost $9 billion in 2007 from trading mortgages. The Volcker Rule either eliminated or severely curtailed prop desks on Wall Street. (Note: The Volcker Rule could be revoked.) Many of these gun-slinger traders who were handed millions of dollars in bonuses despite losing billions for bank shareholders joined or formed prop shops. No one cares whether a trader loses his own money at a prop shop.