What is Prop Trading?

Financial markets are more accessible today than they’ve ever been. People from all walks of life are trading stocks, bonds, forex, commodity futures, derivatives, and any other financial instrument you can think of. 

Good traders are supplementing their incomes and adding to their retirement funds. Great traders are getting filthy rich. 

But before they started having wine and cheese parties on their yacht, they all started with one thing — at least a little bit of cheddar. That’s right. Capital. Cash. 

That’s the rub. You need money to make money.

An increasingly common way to work around a lack of starting capital is to join a proprietary (prop) trading firm. A good prop trading company can help get you started with a little seed money and a lot of guidance. 

Prop trading is definitely not for everybody, so read the following carefully to see if it presents a good opportunity for you. 

Prop Trading: Basic Definition

By the simplest definition, proprietary trading occurs any time a firm uses its own money to trade any sort of financial instruments in order to bolster company profits.

But when people talk about proprietary trading today, they are often talking about something very different from when they used the term in the past. 

Prop Trading: A Quick History

While the meaning of proprietary trading has remained consistent — prop trading is still a firm trying to profit by investing its own capital — the people and institutions that participate in proprietary trading have changed dramatically over the past few years.

Traditional prop trading

In the not-so-distant past, when people talked about proprietary trading, it was almost always with regard to proprietary trading desks at investment banks. Traders on the “prop desk” would buy and sell securities using the bank’s money in the hope of driving up the bank’s profits and earning themselves hefty bonuses in the process.

These trading desks were called proprietary desks to keep them separate from the other traders at the bank who were making trades on behalf of their brokerage clients.

Prop trading and the financial crisis

Everything changed due to regulations passed in response to the financial crisis of 2008. The death of major banks like Lehman Brothers and Bear Stearns and the near-total collapse of the international banking system brought a lot of scrutiny to the big banks. 

The prop desks were an easy target for regulators. When they made massive profits, that money was split up amongst the traders themselves, bank management, and shareholders. When they suffered large losses, however, the entire economy was in harm’s way. 

Lawmakers approved the Volcker Rule in 2010 and began to implement it in 2015. The law essentially took commercial banks and investment banks completely out of the proprietary trading game.

Modern prop trading firms

Proprietary trading didn’t die, however, it just moved to different financial institutions. Although some hedge funds and other asset management companies still engage in proprietary trading, the term, as most commonly used today, refers to independent prop trading firms.

These specialized prop trading firms have a large amount of capital that they entrust to traders in order to boost their company profits. The firms split any profits with the trader according to a predetermined percentage and covers any losses — up to a point.

Different types of proprietary trading companies

Prop trading firms can be more or less broken down into two categories. For simplicity’s sake, I’ve categorized them as Wall Street prop firms and Main Street prop firms.

Wall Street prop trading firms

What I call Wall Street prop trading firms are more or less carryovers from when prop firms were parts of the big banks. Most of them are not physically located on Wall Street, but they act like Wall Streeters. They have massive amounts of capital, Ivy leaguers everywhere, and hire traders with advanced math or computer science degrees.

These are firms like Jane Street, Hudson River Trading, Optiver and Akuna, just to name a few.

If you somehow manage to land a trading job with one of these firms, you will receive a salary, benefits, and a bonus based on your trading profits.

How do you land a job with one of these firms? First, become a child math prodigy, graduate from Stanford as a pre-teen, celebrate your 18th birthday by receiving your PhD in applied mathematics from Harvard, and then wait by the phone.

Ok, maybe it’s not that hard, but you get it — the odds aren’t good.

Main Street prop trading firms

Luckily, there is another type of prop trading firm out there that will offer trading capital to anyone. I call these Main Street prop trading firms because any Jane or Joe off the street can trade with them, even if you’ve never stepped foot on Wall Street.

Here’s how it works with this type of prop firm: First you sign up on their website and pay a fee. Once you’ve paid that fee, you begin a trading evaluation program. Typically you will have to prove that you can generate profits between 8-10% without breaching the firms trading rules.

If you can pass the evaluation, the prop firm will give you a funded account with money in it for you to trade. Whatever profits you make trading that money will be split between you and the prop firm. Typically you will keep around 80% for yourself. If you lose money, the firm covers those losses, but they will probably close your account, and you’ll have to start the whole process over again.

You have to be very cautious with firms of this ilk. Many firms like this profit as much or more from people who continue to fail than they do from splitting profits with successful traders. Their business is based on recruiting as many new traders as they can, and then finding reasons to cancel their accounts or fail their evaluations.

In fact, the CFTC recently shut down My Forex Funds, a very prominent prop firm, in part because they were stacking the deck against traders in order to fail them.

There are, however, some good Main Street prop firms out there that will give you a fair shake.

Advantages of proprietary trading

Why split profits with a prop trading firm when you could just trade your own money and keep all of your profits for yourself? Why jump through a bunch of hoops to pass a trading evaluation when your strategy is already a proven winner?

Although it’s definitely not for everyone, being part of a proprietary trading company has some very distinct advantages. 

Capital

The biggest advantage of proprietary trading is that you will suddenly have access to capital. You are no longer limited to trading your own money. Obviously the more capital you have to trade, the easier it is to maximize profits if you have a successful trading strategy.

Some prop firms will give you up to $1 million to trade right off the bat, although you will have to pay a higher evaluation fee to qualify for that much capital. Most prop firms start you at smaller account sizes, but allow you to scale up to larger accounts once you’ve proven your trading talents.

Education and resources

This is the factor that often separates good prop trading firms from the bottom feeders who are just after your monthly fees. 

Good proprietary trading firms want you to succeed; in fact, they depend on your success to improve their own bottom line. It makes sense then that they would invest in your education and ongoing guidance. 

Really good prop shops will provide advice from seasoned traders and make sure there is always someone around to quickly answer your questions.

If you are interested in prop trading because you already have your own trading strategy in mind and don’t think you need any further training, you should still look into a firm’s educational resources for two reasons. First, because the number of financial instruments are nearly endless and you can always learn something new, and second, because there is a direct correlation between how legitimate a proprietary trading firm is and how much they invest in the ongoing education of their traders.

Don’t join a proprietary trading desk that doesn’t offer training and support. If they won’t invest in you, don’t invest in them.

Limited losses

Another distinct advantage of trading someone else’s money is that you’ve got no skin in the game, other than your evaluation fee. Your prop trading firm will cover all trading losses.

Of course, the downside to that arrangement is if you lose their money, they won’t give you access to it for very long — all prop firms have maximum loss limits. If you lose a certain percentage (usually around 5%) they will cancel your trading account.  

Trading communities

Larger prop trading companies often have Discords, Facebook groups and other online communities for their traders. This can be an invaluable resource. Active trading groups provide trading ideas, can answer any questions you may have, and show you the ropes.

Before you join a proprietary trading company, make sure they have an active trading community.

Disadvantages of proprietary trading

As I said before, proprietary trading is definitely not for everyone.

Evaluations

You’re not going to get trading capital from a reputable prop firm without passing some form of evaluation. Evaluations cost you time and money and success is far from guaranteed. If you fail your evaluation, you’ve perhaps gained some valuable trading experience, but your evaluation fee will not be refunded and you will not receive any compensation for your time.

Prop firm trading rules

Trading with someone else’s money means abiding by their rules. Prop firms will not give you trading capital with no strings attached.

The most basic trading rules involve maximum losses, also known as drawdowns. If your account dips below a certain amount, you will fail your evaluation or, if you are already funded, lose your account.

For some prop firms, max drawdowns are the only real rule, but others may have “consistency rules,” max lot sizes, mandatory stop loss rules, and more.

Never sign up for a prop firm without fully understanding all of the trading rules.

No safety net

One of the biggest drawbacks of trading with prop firms is that you won’t be an employee, which means no benefits and no salary. You’ll make as much as you earn through your trading and not a penny more.

To the super confident among you, this probably doesn’t seem like a problem; you believe in your trading strategy and are comfortable with the risk. 

But even the most experienced traders will make bad trades, the economy is still cyclical and markets never cease to surprise. The question then is, without salary or benefits, how do you cope with the downtimes? Can you put aside enough during the booms to deal with the busts?

Bad prop firms

As I said above, there are some prop firms out there that don’t have your best interests at heart. They try to entice traders to sign up with them, but then actively work against their traders so that they’ll fail their evaluations. Don’t fall victim to bad actors in the industry. Only sign up with established prop firms that you can trust.

How to become a proprietary trader

If the last section hasn’t scared you off, then maybe proprietary trading is a good fit for you. There’s a difference between prop trading jobs at a Wall Street prop firm and joining a Main Street prop trading company as a funded trader.

As I’ve mentioned before, a prop trading job is often extremely difficult to land and usually comes about through college or business school recruiters who go after the best students of math and finance. 

But literally, anyone can join the growing legion of independent proprietary traders by finding a prop firm that offers capital for a one-time or monthly fee.

Some of these types of firms should be avoided, particularly those with really large monthly fees and limited training, but some offer excellent opportunities to learn and profit.

To make it easier for you to choose a prop trading firm, I’ve reviewed the best firms on the market. You can read all about them in my Best Prop Trading Firms article or my Best Prop Trading Firms for Beginners article.