When it comes to trading securities, investors have two main options: principal trading vs. agency trading. Principal trading involves a trader buying or selling securities on their own account, with the goal of profiting from price movements. On the other hand, agency trading involves a trader acting as an intermediary between buyers and sellers, executing trades on behalf of clients.
Both principal and agency trading have their own advantages and disadvantages, and there is no one-size-fits-all answer. It's important to carefully weigh the pros and cons of each strategy and consider how they align with your investment objectives before making a decision.
Table of ContentsPrincipal traders primarily work for their own profits and hold commodities in inventory for others to trade. Here's how principal trading works.
In principal trading — a form of proprietary trading — the brokerage owns the securities it sells, keeping it in inventory. When an investor places a buy order, the brokerage checks its inventory. If it has the commodity on hand, it sells it for its preferred price, pocketing the difference between its purchase price and the investor's requested price.
If the brokerage doesn't have shares in inventory, it seeks shares from other entities, using the firm's capital to buy shares. It holds shares for resale, seeking a profitable selling price.
The difference between the original purchase price and the seller's final price is called the bid-ask spread. Principal traders try to buy low when ordering shares and sell high by timing the market.
Some of the pros of principal trading include:
A few drawbacks could arise in principal trading, including:
Let's say an individual investor wants to buy 50 shares in Airstar Airlines for $20 per share. The investor requests their prop-trading brokerage to make that purchase.
First, the brokerage checks its holdings to see whether it has enough Airstar shares to sell to the investor. If so, it executes the order, the investor gets Airstar shares and the transaction closes.
If the brokerage does not have enough Airstar shares, it obtains them from other institutions. For example, it could purchase the shares at $15 each and sell them back to the investor for $20. As a result, the investor gets Airstar shares at the price they wanted, and the brokerage profits $5 per share.
Agency traders have a clear duty: to represent the interests of their clients above their own. Here's what agency trading entails.
Agency traders put their clients' needs over their company's needs without the double motive of earning income for their firm. To the investor, the process of agency trading isn't that different from principal trading. The investor requests their brokerage to execute a trade.
The agency enters the market on behalf of the client, looking for deals on the securities for the best price and lowest transaction fees. When the brokerage finds acceptable commodities, it buys them and sells them back to the client.
There are a few benefits to agency trading.
Some of the potential pitfalls of agency trading include:
Let's return to the Airstar Airlines example. An investor wants to buy 100 shares at $17 each, so they call their brokerage to set up an agency trade. The agent acts as a go-between for the investor and the party selling Airstar stock.
The agency searches to find someone selling Airstar shares for $17. It places the order on the client's behalf. After the shares are traded, the investor takes ownership of them. The investor pays the agency the requisite fees, and the transaction concludes.
Is principal trading or agency trading the structure that fits your needs? Here are the factors to consider.
Agency traders are intermediaries working strictly on behalf of their clients. To them, everything is for the investor's benefit. Principal traders' primary motivation, by contrast, is to earn profits for the company.
Principal traders working for their profit motives are essentially playing with house money. They may take on riskier positions to generate higher payouts. Agency traders working for clients tend to limit their clients' exposure to risk.
Both principal and agency traders may charge transaction and commission fees. Since principal traders fund their own transactions to make profits, they usually target certain points in the bid-ask spread to generate high earnings. The client could end up paying for the volatility, especially if the trader's activity is impacting the commodity's price.
Agency traders charge fees for trade executions. They seek to earn profits for their clients at the prices those clients are willing to sell. Agency traders are more transparent about where their investors' funds are going.
Deciding what kind of trader will work for your purposes depends on a few factors. Here are some of the most pertinent ones: