How to Start a Proprietary Trading Firm

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Proprietary trading (PPT) firms are companies such as investment banks and hedge funds that use their own capital to invest in bonds, stocks, currencies and other financial instruments, including private companies. A key feature of proprietary trading, and of a PPT firm, is the search for arbitrage, which is essentially a trade in which the firm buys and sells a financial instrument in different markets to profit based on price discrepancies. Starting a PPT firm entails the search for arbitrage opportunities with your own capital in addition to the capital of investment partners. Also, you must research the markets in which you want to invest as well as the types of investments you will make.

Getting Started

Incorporate your firm as an S-corporation to save on taxes and protect your personal finances in the event that the company loses money. S-corporation members, of which a firm can have 100, pay themselves a salary that can be based on market norms, then divide the rest of the company's profits among themselves, according to "Inc." magazine. The salaries are taxed as income and the dividends are taxed at a reduced rate, thereby saving money on taxes.

Review all laws and regulations governing PPT. Legal actions such as the Dodd-Frank Act of 2010 limit the amount of money banks can devote to arbitrage and hedge fund investments, but they can have implications for private PPT firms as well. If you plan to invest in privately-owned firms, for example, you must have a net worth of over $1 million or an annual income of over $200,000 for the past two consecutive years, not counting the value of your home.

Fund your firm with your own capital and capital from your investment partners. Proprietary trading is done with a firm's own money by definition, not on behalf of a client, so use your funds as you see fit and be sure to invite interested investors to buy a portion of the company instead of merely investing their money for them. Keep all business funds in a bank account separate from all personal accounts.

Searching for Arbitrage and Profit

Assign specific financial instruments and markets to partners with the most skill in those areas. Dividing labor among partners showcases each person's skills while preventing burnout, and allows each partner time to seek profit for the firm based on her talents and interests. Work toward a balanced portfolio by investing in various forms of financial instruments.

State the degree of financial risk the firm is willing to tolerate based on group consensus. Financial risk is, in effect, the likelihood that an investment will not return a profit. Consider factors such as the firm's long- and short-term objectives, how much uncertainty you and your partners can tolerate and the return required to accept specific investment odds, according to Southwestern Finance.

Keep accurate records of profit and loss, then prepare financial projections. Opportunities for arbitrage are great for proprietary trading, but they can be difficult to find and are few and far between. Create a financial projection that includes sources of profit and loss, as well as the future of the business if those trends continue.

Refocus the firm's investment activity based on past performance and future projections. The act of creating financial projections and financial statements is important to the health and continued success of a business because it allows you to break from the business routine, take stock of where the company is and establish a plan to steer it where you want it to go, according to "Entrepreneur" magazine. If your firm isn't performing, or if only certain markets are under-performing, redirect your firm to place a greater emphasis on profitable markets and investment opportunities.

Tips

  • Consider writing a formal business plan for your firm. Though they are not a necessary component of beginning a business, they help to clearly state the firm's goals and to establish a course of action. Update your business plan regularly.

Warnings

  • Investing always comes with risk. Never invest money you cannot afford to lose.