Prop trading, short for proprietary trading, means (by its legal definition) that traders trade with the firm’s capital and not their own money.
But what does this mean exactly?
In this guide, I’ll explain how prop trading works, its advantages and disadvantages, what the earning potentials look like, and who can become a prop trader.
Table of Contents
Key Takeaways
- Prop trading is not an investment or trading strategy but rather a legal definition referring to the source of capital used for trades. The prop trader trades with the prop trading firm’s money, not their own
- Not everyone can immediately start as a prop trader. Every trader must first go through an evaluation process. Once you have proven your trading skills, you can trade with the firm’s money and earn profits
- In this guide, I explore the exact meaning of prop trading, show you step-by-step the path to become a prop trader, take a look at the legal situation, and at the same time explain the most important rules of prop trading
Definition: What is Prop Trading?
Many laypeople assume that “Proprietary Trading” is a trading style. However, this is incorrect. Instead, it’s about whose money is used for the trades. Prop traders work for a prop company and use the firm’s own money, not their personal funds, for trading. Any profits or losses from these trades belong to the company, not individual investors.
Trading with Equity vs. External Capital
Regular traders who trade on the stock market with their own money have equity. From a legal perspective, the prop trading firm operates with equity.
The prop trader, on the other hand, uses the capital from the prop trading firm, meaning they trade with the firm’s money.
This eliminates any personal financial risk. And prop traders receive a share of the profits they help generate for the firm.
When trading with external capital, investors transfer money to a fund company. The company then trades according to the specifications of the fund catalog. The company is in possession of the capital but not the owner. A fund always qualifies as a special asset.
While some prop firms might offer the option for traders to invest in the company itself (like buying stock), this is uncommon.
How does Prop Trading works?
In the following sections, I’ll briefly outline the actions of the key players involved in proprietary trading.
The key players in prop trading are:
Additionally, I have prepared an example of prop trading.
What does a Prop Trader do?
The prop trader takes advantage of the opportunities prop trading offers, always trading with a portion of the prop trading firm’s equity. He receives precise instructions and rules to follow for trading. Proprietary traders may employ various strategies, such as index arbitrage or volatility arbitrage, to maximize profits.
When successful, they earn a share of the profits – sometimes a very large share. Top prop firms might even split profits 90% in favor of the trader.
What does a Prop Trading Firm offer?
Unlike traditional investment banks or firms that manage client funds, a prop trading firm engages in prop trading by using its own capital rather than client funds.
The prop trading firm provides the equity for the trades on one side. On the other side, it is responsible for operating the trading platform. An essential point is also the preselection of potential prop traders. The best trading talents are selected through the evaluation process. Only the prop traders that have shown that they can operate profitably in the market trade with real money.
Read more about this in our guide “What is a Prop Trading Firm“.
What does the Broker do in Proprietary Trading?
Almost all proprietary trading companies cooperate with brokers behind the scenes. Brokers are responsible for executing trades on the stock exchange. They facilitate the process by trading on behalf of the prop trading firm. Prop traders place their trades, which are then executed in real time by the brokers.
Trading firms typically team up with brokers to get better results and avoid risks. Ultimately, it is the brokers who ensure the actual profits for the traders and the prop trading companies.
Example of Prop Trading
You are provided with a trading account by the prop trading firm, for example, with capital worth $100,000. You can then place your trades while following the rules. The maximum daily loss and the highest overall loss limit are always important.
A concrete example: You start with a prop trading account worth $100,000. Your profit target is 8%, which is $8,000. With a very good profit split of 90:10, the prop trading firm pays you $7,200 upon reaching the profit target. The remaining $800 is the company’s share of the profit.
If you trade successfully and reach the profit target, you receive your share of the profit. If you fail during the evaluation phase, meaning you do not meet the requirements, you lose your fees. But otherwise, you won’t lose your own money. You never have to invest your own capital in trades in prop trading.
With nearly all prop trading providers, you have multiple attempts to pass the evaluation process. If the initial trades were not profitable, you get another chance, but usually, another fee is required.
Prop Trading: Pros and Cons
Is prop trading more advantageous, or does it come with unpredictable risks? Here, I’ve summarized the pros and cons of prop trading in practice.
Advantages and Opportunities
The key advantage of prop trading is that you don’t trade with your own capital. You don’t have to invest money and, therefore, don’t take on any risk except the initial fee. Yet, you can still earn very good money through high-profit sharing based on your trading results.
Also, prop traders gain a competitive advantage through access to advanced tools and larger capital, which are unavailable to most individual traders. Some prop firms go a step further and might even train you to manage assets, potentially leading to a career as a fund manager.
Disadvantages and Risks
One downside to prop trading is the need to prove your skills before earning. Each firm has different evaluation standards, and failing is possible. You may need to pay multiple entry or reset fees before you’re accepted as a trader. So, starting with a proprietary trading firm usually comes with upfront costs.
Additionally, many providers also charge a monthly fee for data feed provision, access to trading platforms, or other services.
While trading with a prop firm’s capital minimizes personal financial risk, it introduces increased risk in other areas like performance pressure and reliance on the firm’s systems.
Please also note our risk warning regarding the risks.
For whom is Prop Trading suitable?
Prop trading is primarily suitable for private traders who already have some experience. Traders may find prop trading attractive due to high profit potential and access to advanced resources. Now, when choosing a company, pay attention to who exactly the prop trading firm targets.
Recruiters train new prop traders in financial trading. The focus is primarily on education. Other prop trading providers target traders who already have their own trading successes due to the limitation of trading opportunities
Is Prop Trading legal?
Prop trading is generally legal, though specific regulations might vary slightly from country to country.
Let’s learn about the prop trading conditions in some of the most important countries:
Prop Trading in the US
Prop trading is legal in the US. However, there are certain restrictions. For example, us financial authorities have banned CFDs (contracts for difference) being offered to US citizens. Also, the regulatory crackdown targeted the infrastructure behind these prop firms offering CFDs, particularly Metaquotes, the common trading platform provider.
Apart from that, you can trade futures with any prop company in the US. You don’t need any kind of license or permission from any authority to trade with any prop company.
Also, the 2008 financial crisis triggered the volcker rule, restricting large banks from doing proprietary trading to ensure financial stability. However, there’s no restrictions for prop firms.
Any profit you make is taxable income. The actual tax liability could vary depending on individual circumstances, such as deductions, filing status, and other income. It is important to consult with a tax advisor for personalized guidance.
Prop Trading in Australia
Proprietary trading is allowed in Australia. Prop firms are free to trade investments using their own capital.
The APRA (Australian Prudential Regulation Authority) oversees banks and similar institutions (ADIS). Essentially, they make sure banks have enough cash on hand to cover potential losses from prop trading, and that they’re managing risks properly.
The ASIC (Australian Securities and Investments Commission) regulates non-bank financial institutions as well as market conduct. They provide licenses and make sure everyone’s playing by the rules in the markets. This helps prevent things like insider trading, which could cause problems with prop trading.
As a trader, you can engage in prop trading as long as the firm is licensed by the Australian Securities and Investments Commission (ASIC). Profits earned from proprietary trading are generally considered business income and are taxed at your individual income tax rate. You’ll need to report this income on your annual tax returns.
You may be able to deduct certain business-related expenses, such as trading software, data subscriptions, and educational resources. Also, you can use trading losses to reduce your overall tax liability by offsetting other income or carrying them forward to future years.
Prop Trading in Canada
You can legally do prop trading in Canada. There are some good local prop firms in Canada, and if you want, you can trade with international prop firms like FTMO, Instant Funding and Apex Trader Funding as well.
You don’t need any kind of permission or license to do prop trading. However, the prop firms operating in canada must follow the regulations of the Investment Industry Regulatory Organization of Canada.
Prop Trading in New Zealand
It’s completely legal to participate in prop trading in New Zealand. Though there aren’t many local prop firms, international firms like FTMO, Instant Funding and Apex Trader Funding accept residents from New Zealand.
Your profits will likely be considered business income rather than capital gains. Whether you’re trading as a sole trader or a company will also influence your tax obligations.
Prop Trading in the United Kingdom
Prop trading is legal in the UK. The profits may be subject to either capital gains tax (CGT) or income tax. CGT rates are generally lower than income tax. If you operate as a limited company, corporation tax applies.
Regardless of your structure, you must report all gains and income to HMRC. Also, the firm you trade with must be authorized and regulated by the FCA.
How to become a Prop Trader?
Becoming a prop trader usually involves the steps outlined below. While there might be slight differences depending on the firm, this general process applies to most prop traders.
In principle these steps must be followed:
- Choose a reputable prop trading firm: The first step to becoming a successful prop trader is choosing the right company. Under the “Best Prop Trading Firm” section, look for one with a solid reputation and proven track record of safety.
- Registration with a prop trading firm: Your prop trading journey starts with registration and choosing a package. These packages vary in price and trading volume. Some companies even offer different types of accounts (including switchable ones). Choose carefully, as this initial decision will impact your later trading experience.
- Trade on a free demo account: Some prop trading providers offer you the option to choose a free demo account. You can independently place trades to see if the business is suitable for you or not. In this case, you do not need to pay a fee to try the program.
- Evaluation process: Next comes the evaluation, where you prove your trading skills through one or more challenges. This is key to showing your abilities while following the firm’s rules. The trading process is closely monitored to assess adherence to guidelines and trader proficiency.
- Trade on a live account: Once you have successfully completed the evaluation, the provider will provide you with a trader contract that regulates your profit sharing and all other legal matters. You will then do live trading with the capital of the prop trading firm, aiming to generate real returns and maximize their profits.
Earning Potential for Prop Traders
What is your earning potential as a prop trader? I know successful prop traders who earn high five-figure, sometimes even six-figure sums monthly.
Some of the top prop trading firms may offer you the full profit in the initial phase, for example, up to $15,000 or $20,000. After that, the usual profit-sharing applies, which is typically at 90:10 or 80:20.
Scaling programs are often used, meaning your returns increase continuously, for example, from 60:40 to 90:10. This scaling also determines the increase in your trading capital. The more successful you are, the higher your trading opportunities, both in terms of sums and the number of trades.
A concrete example: You start with a prop trading account of $100,000. Your profit target is 8%, which is $8,000. With a very good profit split of 90:10, the prop trading firm pays you $7,200 upon reaching the profit target. The remaining $800 is the company’s share of the profit.
Prop Trader Taxes
Prop traders are always responsible for taxes on their earnings. You must declare your trading profits in the USA (but also in other countries).
You can find all the details in our guide, “Prop Trading Taxes.”
Rules for Prop Traders
During evaluation and actual trading, companies have specific rules. Some allow tools like Expert Advisors (eas) or copy trading, while others forbid them entirely. Loss limits are crucial and must be followed.
Rules also differ on overnight/weekend trading and long-term trades. Many prop firms focus only on day trading, so trading hours are important. Always close open trades before the market closes.
The evaluation phase also requires a set number of trading days. Even if you hit your profit target early, you’re not done yet. You must trade for the minimum required days. While some firms have a time limit for the entire evaluation, the best ones no longer do this.
The most important challenge rules in prop trading are:
- Profit Target
- Profit Split
- Trading Period
- Minimum Trading Days
- Maximum Daily Loss
- Maximum Loss
- Maximum Position Size
- Maximum Capital Allocation and Multiple Accounts
- Trading Types
- Leverage
- Trading Style
- Trading Hours
- News Trading
- Weekend and Overnight Trading
- Expert Advisor
- Copy Trading
You’ll find these challenge rules in all of our reviews so you can easily compare different prop trading companies.
Trading Instruments in Prop Trading
Prop trading always involves specific financial instruments. Traders use a variety of instruments such as futures, CFDs, commodities, forex pairs, or cryptocurrencies to make profits. However, this can vary depending on the firm, so it’s important to understand the specifics beforehand.
Trading Style and Prop Trading Platforms
Day trading is the primary trading style in prop trading, though exceptions exist. The maximum capital you can trade with might be capped by the number of trades you make. Some, but not all, companies offer leverage.
Prop traders trade on platforms such as NinjaTrader, Rithmic, TradingView, Tradovate, Metatrader 4, Metatrader 5, or other portals.
Prop Trading vs. other Investment Forms
In the following sections, I will outline the key differences between prop trading and some other well-known investment forms.
I will make the following comparisons:
- Prop Trading vs. Hedge Funds
- Prop Trading vs. Flow Trading
- Prop Trading vs. Market Making
- Prop Trading vs. Principal Trading
Prop Trading vs. Hedge Funds
Prop trading is different from hedge funds. Hedge funds use partners’ money to invest in profitable opportunities through third parties. They don’t typically execute trades themselves.
Prop Trading vs. Flow Trading
Flow traders specialize in trading commodities, which aren’t always easy to buy or sell quickly. Sometimes, a seller struggles to find the right buyer. This is where flow traders come in, facilitating deals between the two parties and earning a commission in the process.
Prop Trading vs. Market Making
In prop trading, you act as an independent trader, using the company’s money to make your own decisions. Market making, on the other hand, involves buying and selling whenever a customer wants, even if the price isn’t ideal. In practice, new markets (trading activities) are created this way.
Prop Trading vs. Principal Trading
Prop trading mainly focuses on daily trades, while principal trading is quite different. Principal traders buy securities from the secondary market with the goal of holding them for extended periods. Their profits come from long-term price increases.
Conclusion
In conclusion, it should be emphasized again that prop traders use the firm’s money, not their own. They’re essentially trading with someone else’s money and earning a share of the profits in return. This means they work for the company, not independently, and must follow strict risk rules.
When a firm has many prop traders, it spreads out its risk. Some traders will be profitable, while others might experience losses. This diversification of outcomes helps protect the firm from being overly exposed to the risk of a single trader making a significant mistake.
Frequently Asked Questions
Finally, I have summarized some frequently asked questions about prop trading for you.
What is Prop Trading?
Prop Trading is the legal interpretation of trading, where traders work for a company and use the company’s money to trade. Read more under “Definition: What is Prop Trading?“.
Who can become a Prop Trader?
Anyone who has a strong interest in financial trading has the potential to become a Prop Trader. In the section “How to become a Prop Trader?”, you can read how to start your journey together with a prop trading company.
What does trading with external and own capital mean?
The Prop Trader always trades with external capital since they do not invest their own money. In the section “Trading with Equity vs. External Capital“, we have outlined the differences for you.
What are the risks in Prop Trading?
Based on my experience, Prop Trading carries minimal risk. However, many beginners struggle during the evaluation phase, and the initial fees might need to be paid multiple times due to failure to pass. All information is available under “Disadvantages and Risks“.
What chance do I have in Prop Trading?
A major benefit of Prop Trading is the ability to earn profits without using your own funds, eliminating any personal financial risk. Read about the “Advantages and Opportunities” of Prop Trading.
Can you make money in Prop Trading?
Experienced financial market professionals can find lucrative opportunities in Prop Trading, often earning five-figure monthly payouts. All information about earnings and profit possibilities is available to you in the section “Earning Potential for Prop Traders“.
Having more than eight years of trading experience, I know how hard it is to find a good and reliable Prop Trading Firm and not to choose the wrong one. With PropTradingScam.com I want to help you to pick the right one, stay safe, and share your experience.
