Prop trading firms invest their own capital to make profits, rather than using their clients’ money in the traditional way hedge funds or investment banks would. As a prop trader, you can take part in the profits the firm makes without risking your own capital. In this review, we explain the pros and cons of prop trading and explain why it could be an interesting option for aspiring investors.
Best Prop Trading Firms
Prop Trading Explained
Proprietary trading occurs when financial firms such as investment banks, hedge funds, or brokerage firms choose to trade for direct market gain rather than seeking profits by trading on behalf of their clients.
These financial institutions use their own capital to execute financial transactions instead of using their clients’ money. Although risky, prop trading can prove very profitable for financial institutions as they take all the returns from a trade as opposed to just earning a commission for processing positions.
Prop trading can involve investing in stocks, bonds, forex, commodities, derivatives, and other financial instruments.
Prop trading shops often have a competitive advantage over retail investors with unique access to valuable market information to inform decision making. In addition, these institutions benefit from more sophisticated models and advanced trading software.
Investment banks such as Goldman Sachs and Deutsche Bank have been known to earn a significant portion of their profits (and losses) through prop trading efforts.
How Prop Trading Works
In practice, prop trading usually refers to smaller, independent firms that focus on market-making. This occurs when a client wants to trade a large amount of a single security or trade a highly illiquid security. As there may not be many buyers or sellers for this type of trade, a prop trading desk will act as the buyer or seller, initiating the other side of the client’s trade.
For example, if an institutional investor wants to sell 200,000 shares of a stock at $10.00 each but is struggling to find buyers at that price, a market-maker might offer to buy the entire block at $10.00 per share, regardless of whether they have a seller. They would then aim to sell the entire volume for more than the original $10.00 per share price to profit from the overall trade.
Why Start Prop Trading?
Prop funds or prop shops can be an attractive prospect for experienced traders who want to leverage their skillset. However, it can also benefit beginners as you don’t need a lot of capital to get started. There’s zero risk of losing your own capital either as prop firms use their own funds. In addition, most prop firms protect their traders from huge losses by limiting the capital drawdown in line with the firm’s risk tolerance.
Under MiFID I, prop traders were exempt insofar as no other investment services or activities were provided or performed. However, the exemption was further restricted under MiFID II. Under MiFID II, all market makers are subject to license obligations, including those who are active on the derivatives market.
The Volker Rule
Prop traders and hedge funds were among the financial institutions that were accused of causing the financial crisis of 2008. The Volcker Rule, a federal regulation, was introduced in April 2014 to regulate how proprietary traders operated.
The Volker Rule aims to restrict firms from making speculative investments that do not directly benefit their clients. These high-speculation investments were believed to be the cause of market instability. A major concern was avoiding possible conflicts of interest between firms and their clients.
The Volker Rule also aims to limit the amount of risk that financial institutions can take. It banned banks and institutions that own a bank from engaging in certain investment activities with their own accounts, such as prop trading, or investing in or owning a hedge fund or private equity fund.
As a result, most major banks have either separated the prop trading side of their core banking activities or closed them entirely. Specialised prop firms now offer the standalone service. The Volker Rule is generally viewed unfavourably across the financial services industry.
In June 2020, Federal Deposit Insurance Corporation (FDIC) officials said the agency would relax some restrictions of the Volker Rule.
Prop Trading Vs Hedge Funds
The difference between hedge funds and prop trading firms is that hedge funds raise capital from outside investors and use their clients’ money to invest in financial markets whereas prop traders use the firm’s own capital. Hedge funds are paid to generate gains on these investments for their clients.
Unlike hedge funds, prop trading firms get to keep 100% of the money they make. They trade for themselves to bolster the firm’s balance sheet, rather than answering to their clients. Unlike in a hedge fund, a firm’s clients do not benefit from the turnover earned through prop trading. As a result, prop traders can afford to take more risks as they are not dealing with client funds in the way that hedge funds do.
Trading styles between the two differ too in that prop trading firms make profits from market-making while hedge funds bet on security price movements. Algorithmic trading and quant strategies are popular with both firms but are more important in prop trading.
Hedge funds and prop trading firms are similar in that they are both targets of the Volcker Rule.
Prop Trading Vs Sales & Trading
Sales and trading at large banks is about serving clients and executing trades on their behalf. Prop trading firms do not trade for the benefit of their clients. Prop trading barely exists at large banks anymore, thanks to the Volker Rule.
Traders at large banks tend to operate in broader markets with more volume as they have a larger amount of capital available at their disposal. The working environment and culture are different too. Prop traders can work remotely whereas large banks are susceptible to office politics. In addition, large banks are more heavily regulated than prop trading firms.
Prop Trading Vs Retail Trading
In recent years, some retail traders have stepped away from forex brokers and have become investors for prop trading firms.
Prop trading arguably offers more growth potential than traditional investing and traders assume less risk. With retail trading, investors risk their own capital. Retail traders also need to decide whether to withdraw funds or grow their account. With prop trading, both happen simultaneously.
The business model of a prop trading firm is to generate profits. If a prop trader makes a profit, the firm will provide them with more capital. Prop firms want to attract talented traders to optimise their earning potential whereas brokerages earn from traders’ commission or P&L.
The trading environment at prop firms can help nurture beginners, providing education as well as the opportunity to become established professionals. Retail brokers simply give traders access to the market and care less about individual results.
By working for a prop shop, traders can earn a reliable and steady salary. A prop firm will typically pay its traders based on a profit split commission plan where the trader and the firm share the outcome of the individual’s performance.
In most prop companies, the trading platforms used are exclusively in-house and can only be used by the firm’s traders. The firms, and subsequently its traders, gain a huge advantage from owning the software, something that retail traders cannot typically access. With that said, retail traders are increasingly accessing more technically advanced platforms on broker websites.
Prop trading houses tend to be more competitively priced than retail brokers with per-share fees that decrease as volumes increase. The firms may also charge software or desk fees.
- Profits: The main benefit that prop trading provides a financial institution or bank is that it keeps 100% of returns. When a brokerage firm or investment bank trades on behalf of its clients, it earns revenues through commissions and fees which can represent a very small percentage of the total amount invested or the gains generated.
- Stock of securities: Prop trading allows firms to stockpile an inventory of securities. If an institution speculatively buys securities, it can offer an unexpected advantage to its clients. The securities can also be loaned out to clients that want to short sell. An inventory of securities can prepare firms for down or illiquid markets where it could be harder to buy or sell securities on the open market.
- Market making: Prop trading enables a firm to become a market maker. A firm with specific types of securities can provide liquidity for its investors on a specific security or group of securities.
- Technology: Prop traders have access to more sophisticated platforms and other automated software which also enables them to engage in high-frequency trading. In most prop companies, the platforms used are exclusively in-house and only available to the firm’s traders. With more advanced trading technology, prop traders can develop strategies and test the likelihood of success by running demos. However, retail trading is constantly advancing the technical quality of trading platforms.
- Reduced risk: Prop traders make no capital contribution; they trade with the firm’s money. Therefore, there is no risk of losing your own equity.
- Flexibility: Prop trading can be done remotely and prop firms attract many skilled traders who want to leverage their investment knowledge, step away from the corporate office setting, and trade online from home.
- Salary: If you work at a legit prop trading firm, the base salary can start at $100,000. Your bonus can also be 50-100% of your base salary though you won’t receive this if you lose money.
There as some drawbacks of working at a prop trading firm:
- Entry fees: Online prop firms may require a sign-up fee to cover the costs of their qualification tests.
- Trading hours: Prop trading hours can be intense, averaging around 50 hours a week. This will vary depending on the firm and your seniority. Firms are focussed on your P&L so you won’t get a bigger bonus for working more hours. Your hours will also be dictated by the markets you trade and your geographic location. For example, if you’re in London but cover the UK, Europe, and the US, your working hours will be extended to fit those jurisdictions.
- Exit opportunities: Prop trading offers limited opportunities if you decide it is not for you or it doesn’t work out. The skills you develop in prop trading are very specific and may not be useful in other environments. The trading style from that of hedge funds or large banks is very different. Also, if you do not perform well, it makes it difficult to get another job in the same industry meaning a likely career change.
- Legitimacy: It is easy to get scammed by less-than-legitimate prop trading firms. These will often not pay a base salary and may ask you to pay for training.
- Highly competitive: Firms expect decent returns on the capital they invest and delivering on such expectations requires talent and skill. If you don’t perform, it can affect your career in the industry. Also, with more firms online, such as The Prop Trading, an Australian company, competition for seats on a physical trading floor is high.
What To Look For In A Prop Broker
There are a few types of prop brokers to choose from, meaning you can find one that suits your individual needs. As well as knowing your own trading personality and statistics, the following list of prop firm features may help you decide which to choose. It’s also worth checking out detailed reviews.
- Demo vs real account: Some prop firms will evaluate your suitability before providing you with funds. This can be done using either a demo account or a live account. Trading on a real account means instant funding. Therefore, if you are profitable, you’ll receive money sooner.
- Market: It makes sense to prop trade for a firm that specialises in a market that you understand well and have experience in, whether that’s forex, options, crypto, equities, or futures.
- Trading hours: Each prop firm will have specific trading hours. Make sure the firm’s hours suit your own personal timetable. Some firms are restricted to day trading while others allow overnight trading.
- Profit split: Most prop firms set a split agreement with prop traders by the percentage of the profit. Some give a higher percentage to the trader. However, a percentage split does not necessarily reflect the potential profit in actual monetary terms. Make sure you understand what is on offer beforehand.
- Qualifying requirements: Most online prop shops have a testing protocol when hiring prop traders. Normally, your past performance is not taken into account, meaning beginners can start prop trading too. Most qualification procedures are done on demo or simulator accounts but involve real-time trading phases where you are expected to perform under various market conditions. Some prop trading brain teasers and drills are available online.
- Entry costs: There are 3 types of participation fees: subscription (a monthly fee once you are in the program), deposit securities (the fund will observe this to decide how much to add or buy with the trader), and a one-time fee (once you prove to be profitable and responsible for risk, there will be no further cost to you).
- Training programs: Some firms require their prop traders to use their investment strategies. As these may be unfamiliar to you, especially if you’re a beginner, you will have to take an education course before the qualification phase. Be mindful of the costs of these training courses. Experienced traders should also be wary that this might be a sign that the prop fund is just looking for execution traders rather than giving you the autonomy to use your own strategies.
There are other jobs available at prop trading firms other than becoming a trader, including a quant researcher, where you come up with mathematical models for trading algorithms and strategies, and a developer, writing code. There are also support jobs available, such as operations, finance, compliance, and HR.
There are prop trading houses and desks across many cities and countries in most continents:
- Europe: UK (London), Ireland (Dublin), Germany (Frankfurt), Luxembourg, Spain (Madrid), Netherlands (Amsterdam) and Switzerland
- North America: USA (Atlanta, Chicago, New York, Miami, Houston, San Francisco) and Canada (Toronto, Montreal, Quebec, Vancouver)
- South America: Brazil
- Australia: Brisbane, Sydney and Perth
- Asia: India, China (Hong Kong, Shanghai), Japan (Tokyo), Singapore, Dubai and Malaysia
Final Word On Prop Trading
Prop trading is when a firm invests its own money in a particular financial instrument or combination of instruments to bolster its own balance sheet. You can work in a prop trading firm with market practice, a good educational background, and demonstrable investing skills.
For aspiring investors, it’s worth honing your skills with a reputable online broker before exploring opportunities in prop trading firms.
Is Prop Trading Worth It?
There are many advantages to being a prop trader. You have access to more capital to maximise profitability and the money you put in is limited to fees and taxes, reducing the risk that you take. Prop traders also enjoy more freedom than a normal finance job.
Is Prop Trading Illegal?
The Volker Rule is often referred to as a ban on prop trading by commercial banks although some exceptions to this ban exist. As a result of the Volker Rule, most major banks have closed their prop trading desks. However, prop trading is still carried out at specialised firms.
How Much Money Do You Need To Be A Prop Trader?
Prop traders do not need any capital but the firm will keep all of the trader’s profit. In return, they usually give the prop trader a fixed salary as compensation. Most firms have a monthly fee in the range of a few hundred dollars for using the platform.
How Do Prop Traders Make Money?
Most prop traders make money by taking a share of the profit they make by executing trades on behalf of a prop firm. Returns can be multiplied depending on the additional capital provided by a trading firm. Many prop trading firms offer a fixed salary and a bonus based on performance.
Who Are The Best Prop Trading Firms?
In 2023, among the top 5 forex prop trading firms are FTMO, TopStepFX, Fidelcrest, The 5%ers, and City Traders Imperium. However, the top 5 prop trading firms as voted by their peers are Jane Street, Hudson River, Optiver, Tower Research, and Virtu.