8 Top Prop Trading Strategies

Although the landscape of proprietary trading (prop trading) is relatively nascent compared to the history of the financial markets, it is a rapidly growing phenomenon. The global prop trading industry is estimated to have reached $6.7 billion in 2020 and is projected to expand at a CAGR (compound annual growth rate) of 4.2% between 2021 to 2028.

Prop trading firms allocate their own capital to traders, allowing them to trade various financial assets. Traders are given the flexibility to make trading decisions. When they make gains, a part of this needs to be given to the prop trading firm. This makes it a win-win for both. Traders can open much larger positions than they could have with their own funds, while prob trading firms make money from the gains booked by traders. Apart from capital, prop trading firms provide deep analysis and insights to support traders when making trading decisions. 

The Most Popular Prop Trading Strategies

Since prop firms provide the capital for trading, prop traders usually follow high-paced trading strategies to maximise their profit potential. This is supported by the exceptional trading resources, cutting-edge analysis tools, and deep insights from market experts provided by prop firms. 

Some of the most common prop trading strategies are:

1. Merger Arbitrage (Spread Trading)This strategy is used in stock trading. Traders following the merger arbitrage strategy aim at exploiting share price differences that may appear during an M&A (merger and acquisition) deal. The difference arises between a target company’s stock and the acquiring company’s stock. Prop traders go long on the target company’s stock and short sell the acquiring company’s stock. The aim is to profit from the spread between the current share price and the eventual merger terms.
2. Index ArbitrageThis strategy involves aims at profiting from price differentials in indices. Prop traders can use index arbitrage to take advantage of the price difference between the same index in different exchanges or between two indices that are correlated.
3. Volatility Arbitrage In this trading strategy, the prop trader aims to profit from the difference between the expected volatility in an asset’s price and the volatility implied in the asset’s derivatives. The success of the prob trader is based on how accurately they can predict whether the implied volatility in the derivative is over-or under-priced. 
4. Pairs TradingPairs trading involves taking a long position in one asset and shorting another that has a positive correlation with the first. The idea is to profit from the expected convergence of their prices. For this, prop traders need to identify forex pairs or other financial assets that have a strong correlation. Prop trading using this strategy also relies on technical analysis to identify assets that have deviated from their historical patterns. It is a very fast-paced strategy that aims at making small profits from short-term price movements.
5. Opening OrderThis prop trading strategy involves placing orders at the opening bell of the market. If the price of an asset declined sharply in the previous trading session, the prop trader anticipates the market to reverse and opens orders at the opening bell to capitalise on the move. 
6. ScalpingScalping involves placing a large number of trades of small values in a single asset. The aim is to make profits from small price movements in the asset. The idea is to capitalise on fleeting market inefficiencies and is a very fast-paced trading strategy that requires a great deal of precision and timing the market.
7. Global Macro-TradingIn this, the prop trader bases trading decisions onglobal economic events to trade assets like forex and commodities. These could be economic data releases, central bank announcements, or geopolitical developments. Some events could impact several markets, and the prop trader may decide to open positions in different assets to capitalise on the event.
8. News Trading In news trading, the prop trader places trades based on certain significant events by predicting the impact of the event on market sentiment. This is done to capitalise on short-term opportunities just before and after the event. For instance, the news could be the announcement of election results or the release of minutes from a central bank meeting. It could also be major economic releases, like the US NFP (nonfarm payrolls) report or UK’s GDP growth data. 

Remember: It’s important for prop traders to choose the trading strategy that resonates with their trading style, financial goals, and risk tolerance.

Risk Management in Prop Trading

Since prop trading strategies typically involve high frequency trading and deploying much more capital than an individual trader has, it requires astute risk management. Selecting the exit points is equally important as identifying entry points. This is why it is critical to place stop loss and take profit order with every position opened. 

Prop traders must also consider hedging and portfolio diversification for sound risk management. Optimum position sizing is another way to ensure that a few trades do not significantly erode the trading capital at the prop trader’s disposal.

To keep emotions from impacting their trading decisions, prop traders often rely on algo trading, which involves the use of programmed systems to identify optimal trade setups and make decisions based on predetermined criteria.

Staying Abreast of News

Being aware of economic data releases and the latest economic and political developments is important even for those who are not news traders. Success in prop trading depends on the trader’s ability to quickly respond to market moving events and adapt to a constantly evolving market. 

To Sum Up

• Since prop firms provide the capital for trading, prop traders usually follow high-paced trading strategies to maximise their profit potential. 
• Among the 8 most common prop trading strategies are Merger Arbitrage, Index Arbitrage, Volatility Arbitrage, Pair Trading, Opening Order, Scalping, Global Macro-Trading, and News Trading.
• Although trading is done with the prop firm’s capital, the prop trader must choose the strategy that aligns with their trading styles, financial goals, and risk tolerance.
• Risk management and staying abreast are critical for all prop trading strategies.  

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