How Do Prop Firms Work? Have you ever dreamed of making a living as a trader but don't have the funds to start? Prop trading firms may be the answer you've been looking for. These firms provide traders with access to large amounts of capital in return for a portion of the profits. But becoming a prop trader isn't as simple as it sounds. In this article, we'll dive into what prop trading is, how prop trading firms operate, and what you need to know before taking the leap.
What is prop trading?
First of all, let's define what a prop trading firm is. Traditionally, prop trading, or proprietary trading, refers to investment banks, hedge funds, and other financial institutions directly trading in the stock, commodities, bond, and Forex markets. They employ traders to trade and invest their capital, allowing them to generate additional profits alongside their regular activities, like providing investment services and managing client portfolios. However, with the advent of online trading, there are now online prop trading firms that offer individual traders across the globe the opportunity to trade with the firm's capital. This allows them to trade with much more significant sums of money than would be normally available to them and potentially generate much greater profits. The firm will take a cut of the profits, usually ranging anywhere from 50% to 95%, in exchange for providing the capital, technology, and resources. It's important to note that online prop trading firms don't operate the same way as traditional prop firms. Online prop firms do not act as intermediaries between traders and the market; instead, they provide traders with direct access to the markets and their own capital to trade with. This means that traders are solely responsible for their own trades and must have a solid understanding of the markets, risk management, trading strategies, and their own psychology.
How prop trading firms operate?
In practice, these prop trading firms generally provide traders with capital and a demo account that fully simulates live markets with no perceptible differences. The prop firm will then copy the trades using a combination of automated and discretionary decision-making to execute the trades for real, enabling them to make a profit or loss without any risk to the trader. While this sounds like an ideal situation for any would-be trader, becoming a prop trader requires going through a stringent evaluation process, often termed a "challenge," paid for with an upfront fee. This is because the prop trading firm is taking on a significant amount of risk allowing traders to use their capital. The evaluation process determines whether the trader has the necessary skills and knowledge to trade profitably and responsibly.
Risk management
Once accepted, prop traders are held accountable to strict risk management guidelines, such as maximum daily losses and overall losses, to help protect the firm's capital. However, this is a fair deal, considering that some of the best prop trading firms can allow traders to deploy hundreds of thousands, even millions, of dollars in the markets without taking on any risk themselves. In combination with generous leverage and ongoing support, this setup can help traders achieve much greater profits than they could earn on their own. That said, if they breach these guidelines, traders can find themselves subject to account closure. While many of the best prop trading firms will allow traders to retake the challenge, some won't, so be sure to check the terms and conditions of the prop firm you sign up with.
Progression
Most prop firms and FX trading prop firms will provide traders with a progression scheme. If the trader proves themselves capable of being able to trade safely and effectively, they'll have the chance to climb the ranks and be given more capital to trade with. The rate of progression varies from firm to firm and industry to industry; some will review your account after three months and determine whether you're suitable for an upgrade. Others will define their progression terms from the get-go, giving traders set progression targets to work towards.
Tradable assets
Which instruments the prop firm offers will depend on the individual company. Some will exclusively focus on Forex trading; others will prioritize trading in the stock market. This enables the firm to focus on recruiting the best talent for its area of expertise, as they'll often be able to tailor support, mentorship, and software to the kinds of traders they're looking for. Forex trading prop firms, for example, might feature regular seminars from experienced currency traders and work to minimize spreads for traders investing in the foreign exchange market. Stock trading prop firms, meanwhile, may offer specialized scanners to help traders find opportunities or provide market analysis from seasoned equity traders. Generally speaking, however, many prop trading firms will allow traders to invest in a wide range of markets, including the Forex market, commodities, and crypto. While the selection is typically more limited than you might get with your regular broker, the choice of assets should be more than enough to keep you going.
How do prop firms make money?
While we've briefly touched on how prop trading firms make money, it's worth covering it in a little more depth to better understand how prop firms work. Prop firms offer an extraordinary opportunity for traders to take on minimal risk while exposing themselves to potentially lucrative returns. The freedom to trade on your own time and access to huge sums of capital come at a cost, however, usually in two ways: the challenge and the profit split.
Challenge
The challenge refers to the evaluation process traders must undertake to become a fully-fledged prop trader. The fee traders pay to take this challenge will be proportional to the amount of capital the trader has access to if successful. For example, a challenge for a $10,000 account with one popular prop trading firm costs around €155, while its $200,000 account challenge requires traders to pay €1,080 just to get started. If the trader fails the challenge by breaking one of the specified guidelines, they lose their initial fee. Some will offer a free retake, but this is ultimately up to the discretion of the individual prop firm. There are usually four ways a trader can fail a challenge:
- Maximum loss: The most important metric of all is a trader's total loss. Depending on the firm, this can range from 4% to 10%, although a more liberal loss limit will often cost more upfront. Note that this will commonly entail losing 4% to 10% of the initial account balance (reaching $9,600 on a $10,000 account, for example) and not from any gains made.
- Maximum daily loss: If a trader loses a specified percentage on a given day, they can also fail the challenge, even if they don't hit the maximum loss limit. Some prop firms don't use this metric, but the ones that do will often allow at most 5% to be lost on a single day. This will also apply to the starting account balance and not to profits made.
- Maximum time: Traders will typically be given a set number of days to complete the challenge. These time limits are usually reasonably relaxed, ranging from 30 to 180 days, but traders will automatically be disqualified if the challenge isn't completed within this time.
- Profit target: Finally, traders must prove they can use their skills to generate a profit. Again, these targets vary from firm to firm, but they usually range from 5% to 10%.
If traders choose the aggressive account type available with some prop and FX trading prop firms, they're often given wider loss limits and higher profit targets. For instance, they may be given a maximum loss of 20% but must also meet a profit target of 20%. There is one metric not listed, as its use can be inconsistent across various prop trading firms: minimum trading days. In a 30-day challenge, for example, traders may be required to place a trade on at least ten of those days. Others may specify that traders place a trade three days out of the week, while some have no minimum trading days at all. Of course, while much of the profits earned by prop firms come from successful traders with high account balances, they know that many will be unsuccessful in passing the evaluation stage, enabling them to keep the fee paid by the trader. If they are successful, however, most firms will refund the fee.
Profit split
If traders pass the evaluation stage, they'll be subject to handing over some of their profits to the prop firm. How much profit is split between the firm and the trader depends on both the individual firm and the program the trader is on. More often than not, the firm will take a more substantial cut of the profits at the start of the trader's journey. Many will take 50% of the profits, but some have been known to take as much as 70% or more. That said, the best prop trading firms may start allowing traders to keep 80% or even 90% of the profits, but these programs might be slightly pricier upfront. As traders continue to meet their targets and stay within the risk management guidelines, the profit they can keep tends to increase. For example, if they started on a 50/50 profit split, the next stage might reduce the firm's share to 25%. Or, if they began on an 80/20 split, traders may progress to a 90/10 split. Some firms let traders keep 100% of the profits. This is generally only for advanced traders that have consistently proven themselves and worked their way up through the program, being given millions of dollars to trade with. While only certain prop trading firms offer this, it highlights the exceptional earning potential that prop trading can provide. Traders can often withdraw their profits on a bi-weekly or monthly basis, providing them with a regular income stream. However, the frequency of withdrawals will vary depending on the prop firm and the trader's agreement with them. Some prop firms have restrictions on the minimum balance required for withdrawal, although these limits are usually set relatively low.
Pros and cons of prop trading firms
While this setup seems like the perfect arrangement for any trader looking to get their big break, you should consider both the pros and cons of prop trading firms before starting your journey.
Pros
- Freedom: As a prop trader, you have the freedom to set your own schedule and the autonomy to make your own decisions.
- Profit potential: If successful, prop traders for the best prop trading firms can make a significant profit without making much of an upfront investment. It might cost only a few hundred to take and pass the challenge before making several thousand the next month.
- Minimal risk: Since much of the risk lies on the firm, prop traders only risk their initial investment in taking the program. Beyond that, losses are absorbed by the prop trading firm.
- Progression: Many of the best prop trading firms have excellent progression schemes that allow traders to set realistic targets and grow their monthly income.
- Access to capital: Traders will rarely have more than a few thousand they're willing to risk on the foreign exchange market. Instead, Forex trading prop firms can potentially offer traders access to significant sums of capital to use on the currency market within weeks.
- Support: Prop firms often have tight-knit communities of traders that help each other out and provide insights into their own strategies. Moreover, many feature quick phone or live chat support if you have any issues.
Cons
- Requires discipline: To be a prop trader, you must have discipline and mental fortitude. You'll need to make sacrifices, whether that means spending hours examining the charts looking for the perfect opportunity or creating an iron-clad routine to help you trade successfully.
- Trading psychology: Related to discipline, you need to be a master of your own emotions. Revenge trading or taking overly-risky trades just won't cut it.
- Upfront fees: If you have limited income, the initial evaluation fee could seem like a significant upfront investment to make, especially for accounts with larger balances.
- Income can be irregular: At the end of the day, you work for yourself as a prop trader. You don't have the luxury of sick pay or a predictable monthly salary.
Final thoughts
Overall, prop trading can offer traders an exciting opportunity to invest with substantial amounts of capital and earn life-changing sums of money. However, it's essential to understand that becoming a prop trader requires hard work, dedication, and tip-top risk management skills. It's crucial to thoroughly research and choose a reputable prop trading firm that aligns with your goals and values while providing adequate support and clear-cut rules. The process of becoming a successful prop trader can be challenging, but with the right mindset, approach, and strategy, it can be an incredibly rewarding experience.
