Prop trading or hedge fund? That can be the literal million-dollar question in the end. But why?
As we progress in the world with the contemporary financial system that governs our world, more and more people are being lifted out of poverty. And unlike what you hear about the income disparity becoming larger, the circulating capital among people has never been higher in the history of mankind.
With this high circulating capital, it is only natural that people would be thinking about different ways in which they can invest this capital and hopefully get some return on their investment in order to increase their assets.
That being said, many have turned to various markets and trading in them, including the forex market or the stock market.
Of course other available options are using a hedge fund or a prop trading firm. Perhaps a hedge fund is more widespread and well-known, but prop firms are certainly gaining traction.
So it is finally time to do away with all the confusion and find out once and for all if prop trading is better than hedge funds. We will look at both of these options in detail and then compare them.
What Are Prop Trading Firms and How Do They Work?
Prop trading, which stands in its full form for proprietary trading, is a form of trading in which a firm will use all its available capital, i.e. its disposable liquidated assets, and use them to trade directly in a financial market. This financial market can be any market such as the forex market or the stock market.
In addition, there are also prop trading firms which engage in this form of trading in various ways. For instance, there are firms that engage in prop trading directly as a means of investment and profitability. There are also other prop trading firms whereby they provide assets to other traders in order to take that asset and then directly trade with them in the financial market.
This is seen a lot with prop trading firms, where they even provide traders with stupendous leverage rates that can be as high as 1 to 100 or 1 to 200. They also provide funding and scaling options in order to increase the trading capital of traders. In this case they profit indirectly through the profit that is made by the traders.
So the way prop trading works is either when a company engages in prop trading itself in order to protect its assets from being static for too long and wants to keep them in circulation, or when a company, known as a prop trading firm will facilitate the process of trading in financial markets for other traders and provides them with leverage or funding and then profits from the pooled resources and expertise of many traders.
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Important Features and Advantages of Prop Trading
Given the peculiar nature of prop trading, there are also peculiar features associated with it as well. For instance, prop trading, unlike hedge funds and other capital investment firms, gets its profits as a percentage from the traders’ profits. So however much money traders have put in and however much they make profits accordingly, the prop firm will get a piece of that as its own profit.
On the other hand, in prop trading, whether carried out by traders or companies themselves, we have extremely sophisticated methods of risk management and that is because prop trading is inherently a risky business. Well that would only be natural when you are dealing with a huge sum of money.
Of course there must be enough upsides to this form of rather risky trading; otherwise why would anyone bother with it. When you engage in prop trading with the help of a prop trading company, you will have access to a huge sum of capital through the leverage that they provide for you. This leverage can be as high as 1 to 200 or in certain cases 1 to 1000.
Additionally, because of the mere volume of money that is in disposal of prop traders, these firms would normally hold many tutorial and educational courses for traders in order to make sure they have their expertise in check to provide an extra layer of risk management given the considerable capital.
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What Are Hedge Funds and How Do They Work?
Hedge funds are sort of like the establishment in the money management business, while prop firms are the rebellious young people trying to make a wave. It means that hedge funds have had a longer root in the finance world compared with prop firms.
The way they work is actually pretty similar. So in the case of a hedge fund we have a financial firm that gathers investment from other clients or other companies. The resulting pool of capital is then used in order to make other investments and also for trading purposes. The hedge fund itself will make profits through the commissions or fees.
Naturally, hedge funds deal with a lower level of risk since they ordinarily would opt for more reliable investment opportunities. This low level of risk would also equate to a lower level of profits – generally speaking and especially compared with the high end profitability that we see with prop trading.
Important Features and Advantages of Hedge Funds
The most important feature of hedge funds is that they are reliable. Since they are usually dealing with highly affluent individuals and institutions, their investment options are almost always safe and reliable. This is why many other funds, such as retirement funds and programs, would even trust hedge funds with their money and give their capital to these firms for management and investment.
It is also worth mentioning that due to the longer term approach that a hedge fund has toward investment, sometimes the return that they experience can even be higher than that of a prop trading firm.
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Is Prop Trading a Better Option vs. Hedge Funds?
So let’s get back to the original question posed at the beginning of this article. Which one is better, hedge fund or prop trading? Well, the answer to that question really depends on you and your conditions for investment or trading. To find out which one suits you more, let us take a look at the differences between these two.
First of all, hedge funds pool their capital, which means they gather money from investors and the resulting assets would make up the capital that they use for investment. On the other hand, prop firms use their own capital and trade directly in the financial markets.
Plus hedge funds are more heavily regulated compared with prop trading firms. The reason is that hedge funds manage money that is taken from their clients, while prop firms have their own money and also the capital from their traders.
So it seems that these two modes of investment/trading are completely dependent on your needs and the status of your assets, the amount of risk you can tolerate, and most importantly your profit goals.
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Hedge funds and prop firms are two sides of the same coin. They are both basically used as a means of asset management. While they share many similarities, they have key differences, such as the source of their capital for investment/trading. While hedge funds have an external approach, prop firms look inward for this source. In this article we discussed both of these approaches at length and also compared them against each other.