Trading desks can make money in three basic ways:
1. Buy low, sell high.
2. Manufacture a product and sell it, taking a cut.
3. Take a view on where the price is going to go, then take a position accordingly.
1. is basically market making. You can either wait until you have a matching trade and take a cut (=exchange, broker). Then you're always flat (that is, you don't care where the price moves - you always get your cut). Or you can post bid and ask at which you are prepared to trade. When someone avails themselves of this, you then have a position, and the market might move against you. The spread compensates for that risk. Key here is to distinguish informed traders (that offload stuff on you before the price drops due to some news) from "dumb money", aka noise traders, that just want to buy or sell some stuff, but don't have information where the price will go. The latter make you money on average, the former might cost you.
2. That's basically manufacture of derivatives, say. You buy or sell an option, charge something on top of the computed price, and then trade underlyers against it to be flat, and at the end ideally realise that charge.
3. This is basically prop trading. If you put on the proper position, and your view turns out right, you make money, otherwise you lose. You need to be right more often than wrong :-) and quite some capital cushion to balance out the wins and the losses.
So, prop trading is characterised by you NOT being flat, i.e. you are exposed to market moves. As someone pointed out, when you are market maker, you are also exposed, but it's for short periods of time, and not the main goal. However, this does introduce some ambiguity.
1. is basically market making. You can either wait until you have a matching trade and take a cut (=exchange, broker). Then you're always flat (that is, you don't care where the price moves - you always get your cut). Or you can post bid and ask at which you are prepared to trade. When someone avails themselves of this, you then have a position, and the market might move against you. The spread compensates for that risk. Key here is to distinguish informed traders (that offload stuff on you before the price drops due to some news) from "dumb money", aka noise traders, that just want to buy or sell some stuff, but don't have information where the price will go. The latter make you money on average, the former might cost you.
2. That's basically manufacture of derivatives, say. You buy or sell an option, charge something on top of the computed price, and then trade underlyers against it to be flat, and at the end ideally realise that charge.
3. This is basically prop trading. If you put on the proper position, and your view turns out right, you make money, otherwise you lose. You need to be right more often than wrong :-) and quite some capital cushion to balance out the wins and the losses.
So, prop trading is characterised by you NOT being flat, i.e. you are exposed to market moves. As someone pointed out, when you are market maker, you are also exposed, but it's for short periods of time, and not the main goal. However, this does introduce some ambiguity.