This guide aims to provide a detailed understanding of proprietary trading, including how they work and how to choose one.
Proprietary trading, often referred to as “prop trading,” is a unique and complex aspect of financial markets, where firms engage independent traders to trade financial instruments on their behalf using their capital.
This guide aims to provide a detailed understanding of proprietary trading, covering key topics such as the inner workings of prop trading companies, the pathway to becoming a prop trader, potential earnings, and considerations for choosing the right prop trading firm.
What is Proprietary Trading?
Proprietary trading involves financial firms using their funds to trade various financial instruments, including stocks, bonds, commodities, currencies, and derivatives. The primary goal is to generate profits for the firm’s own trading activities and market positions.
Unlike traditional banks that facilitate trades on behalf of clients, prop trading firms trade using their accounts. Their traders enter trades based on the firm’s independent research, strategies, analytics, and risk parameters. Traders are compensated based on their trading performance and the profits they generate.
Some of the notable players in proprietary trading include:
- Hedge funds
- Investment banks
- High-frequency trading firms
- Commodities trading firms
It’s worth noting that prop trading is different from market making and other forms of trading done on behalf of clients. Prop firms directly accrue any profits or losses generated. They neither provide liquidity nor aim to profit from bid-ask spreads.
How Does a Prop Trading Company Work?
A prop firm is essentially any company that offers its traders access to capital for trading. Prop firms make agreements with independent traders (not employees or clients) to conduct trades on the company’s account. Prop traders use the company’s pool of capital, and in return, they share a percentage of the profits they generate with the firm.
This is a win-win for both parties – traders gain access to capital and sophisticated trading tools, and the prop firms enjoy profits from professional traders. However, becoming a prop trader requires passing several challenges provided by the prop firm to prove that you’re a consistently profitable trader and that you have their best interests at heart.
Keep in mind that if you get funded by a prop firm, you have to follow their rules and guidelines, and the profit-sharing agreement will vary from firm to firm. You must also account for potential conflicts of interest since most prop firms already have their own goals and strict strategies that may not align with the traders they fund. It’s therefore important to understand their expectations and overall strategies before you sign up with a prop firm.
Types of Prop Firm Accounts
Proprietary funds offer you great flexibility when it comes to the markets and assets you can trade. Traders essentially have the capital to trade futures, forex, options, crypto, and shares. With this in mind, let’s look at the types of proprietary trading firms available today.
Remote/Online Prop Firms
These are the newest and most modern versions of prop trading firms. They are designed to work entirely virtually or on the Internet and offer traders with funded accounts with similar rules and principles as the traditional prop firms.
The popularity of online prop firms has risen significantly over the past few years, with firms such as FTMO and their aptly named “FTMO Challenge” being one of the most popular. Other popular remote prop firms include The 5%ers, Earn2Trade, and TopStep.
Traditional Prop Firms
These are some of the biggest, albeit the older proprietary trading companies in the industry. Traditional prop firms typically hire their traders and allocate them funds to trade, giving them a closer resemblance to hedge funds.
In many cases, traditional prop firms have their in-house trading techniques, which gives them a greater edge in the market. Some will focus on strategies such as arbitrage, while others are experts in algorithmic trading. Some of the largest traditional prop firms include Lux Trading Firm, Jane Street, and Jump Trading.
Unlike online/remote prop firms, it’s nearly impossible for new traders to join. They have a long recruitment process, which means only a limited number of applicants manage to get in.
Proprietary trading Shops
These are a category of prop firms where the trader is required to have a substantial amount of capital, among other specific requirements, as part of the recruitment. The prop shop will then provide the eligible traders with additional capital.
Understanding Prop Trading Firm Strategies
The main goal of a prop firm is to make money from the financial markets by hiring traders to manage their capital. They employ several strategies, including algorithmic trading, high-frequency trading, and quantitative trading to make these profits.
Strict Trader Evaluation: Proprietary trading firms also have a rigorous evaluation program to ensure that they only let in the most talented traders. They often evaluate the traders’ experience, skills, and performance to establish if they are suitable for the firm’s strategy. Traders who end up being funded are also given targets to achieve.
Smart Capital Allocation: Prop firms will allocate a percentage of their pool of capital to traders or trading desks. This capital is meant for executing trades and generating profit. The amount of capital allocated varies based on the trader, the program, and the firm’s unique criteria.
Risk Management: Prop trading firms employ sophisticated risk management strategies to mitigate potential losses. These may include setting position limits, using stop-loss orders, and employing advanced analytics to assess market risk.
Trading Strategies: Firms develop and implement various trading strategies, such as algorithmic trading, high-frequency trading, and quantitative trading, to capitalize on market opportunities. Prop firms are also known for their high-performance culture and competitive work environments. They expect all their traders to perform at their level best and meet their targets.
Market Access: Prop trading firms often have direct market access, enabling them to execute trades swiftly and at advantageous prices. This is crucial for implementing high-frequency and algorithmic trading strategies. They also invest in modern trading technologies and market data to help their traders make informed trading decisions.
Prop trading firms are a great option for traders looking to access higher capital and increase their profits. However, it’s important to do some thorough due diligence and only work with reputable firms that have proven fair practices.
How to Become a Prop Trader?
The entry requirements for prop firms will vary significantly from firm to firm. However, generally speaking, many trading firms are not super strict about qualifications, trading experience, and level of education. Some will even consider new traders so that they can shape their trading strategies and styles based on the firm’s requirements.
Becoming a proprietary trader usually involves the following:
Develop your trading skills: You first need to develop your trading skills and gain some experience trading through education and practice. This typically involves thoroughly studying the financial markets, developing trading strategies, and practicing trading through demo accounts or small-scale real accounts to gain experience.
Educational Background: While a formal education in finance, economics, or a related field is beneficial, it’s not always a strict requirement. Many successful prop traders come from diverse educational backgrounds.
Skill Development: You should consider developing strong analytical and quantitative skills and familiarizing yourself with the financial markets, technical analysis, and trading platforms to become a successful prop trader. Consider obtaining relevant certifications if necessary. Many prop trading firms prefer candidates with prior trading experience.
Once you’re confident in your skills you can apply to join a suitable prop firm. This will generally involve successfully passing a rigorous evaluation process, which will test your performance in simulated or live trading. If you’re successful, you will be offered a position as a trader.
If you trade forex, stocks, futures, cryptocurrencies, and other derivatives, proprietary trading firms could potentially offer you a great career path, especially if capital is an obstacle. You could not only gain experience while trading for these companies, but also make a lot more money than you would trading your capital, and perhaps even set yourself up to move to larger trading desks.
Pros and Cons of Becoming a Proprietary Trader
Just as with any other profession, there are pros and cons to becoming a professional prop trader. Understanding the benefits and drawbacks of proprietary trading is essential when deciding to take this path. The following are the main pros and cons of being a prop trader:
Pros:
- Gives you access to a huge pool of capital, financial services, and technology resources.
- In-built risk management parameters to minimize drawdowns and enhance consistency.
- Most firms do not pass financial risk to the trader.
- Huge earning potential.
- Professional training resources and access to professional traders.
Cons:
- High competition, with highly demanding risk parameters and profit targets
- No salary – you only make money if you’re profitable.
- Certain account limitations exist as part of risk management.
- Profit sharing will cut into your bottom line, unlike a private account.
- Underperforming or breaking some rules could have your account suspended.
How Much Money Can a Prop Trader Make?
The sky’s the limit! However, do note that prop traders’ earnings do vary widely and are often tied to performance, the size of the firm, and the profit-sharing ratio. Some firms offer a flexible profit-sharing ratio based on the trading strategy and the trader’s experience. Profit-sharing ratios range from 75/100 to 90/100.
There’s no general rule for making money with prop firms – the money you make will largely depend on the profitability of your trades, the commission charged, your account size, and your trading strategies.
It’s also worth noting that while prop firm trading can be lucrative and profitable, it’s also affected by asymmetric risk. This is especially true when you consider that the profit-sharing ratio might be 80/100, but you, as the trader, bear 100% of the risk on your trades.
How to Choose a Prop Trading Firm?
There are several factors you want to consider when choosing a prop firm partner. The following are some of the most important factors:
Reliability
You want to partner up with a reliable proprietary trading partner. Make sure that the firm is reputable, trustworthy, and reliable. To verify this, you may have to invest some time to do your research and if possible, see what other traders in this field are saying about the firms you’re considering.
Risk Parameters
Understand the firm’s risk management policies and parameters. A reputable prop trading firm will have well-defined risk controls in place. It’s also important that the prop firm provides you with enough capital to be able to make the trades you want to make, based on your trading strategy and financial goals.
Profit-Share Requirements
As mentioned earlier, all prop firm trading accounts will be subject to a profit-sharing ratio. This means that you will have to share the profits you realize with the firm, based on their profit-sharing rule. The profit-share ratio may vary widely, and it’s important to keep this ratio in mind when choosing a prop firm.
Technology Infrastructure
Assess the firm’s technological capabilities, including trading platforms, data feeds, and execution speed. Cutting-edge technology is crucial for success in prop trading. Some of the most common platform options on prop firms include MT4 and MT5 MetaTrader and NinjaTrader.
Other proprietary technologies and platforms might be offered as well. Make sure that the prop firm you choose has the technology tools you need in your trading approach.
Training and Support
Look for firms that offer comprehensive training programs, mentorship, and ongoing support. A supportive environment enhances the learning curve for aspiring prop traders. It’s also wise to see if the firm provides access to experienced traders, who can offer insights and guidance where needed.
Account’s Terms and Conditions
Being well acquainted with the prop firm’s terms and conditions is important when it comes to prop firm trading. The terms and conditions essentially outline the payment policies, risk management parameters, and essential business practices. Checking these can help you decide if a given prop firm is right for you.
Closing Thoughts
Proprietary trading is a dynamic and challenging field that requires a combination of skills, experience, and a thorough understanding of financial markets. Now that you understand how prop trading companies operate, the steps to becoming a prop trader, potential earnings, and considerations for choosing the right firm, you can make better decisions when venturing into this exciting and rewarding realm of finance.
