In recent years, prop trading firms have established themselves in the financial market with their business model. These firms are proprietary traders that collaborate with external traders (prop traders) in their trading activities.
But what exactly is a prop trading firm, and how do they make money?
In this guide, I will explain how a prop trading firm works and what opportunities and possibilities this business model offers for you.
Table of Contents
Key Takeaways
- Every prop trading firm tries to convince potential prop traders with its unique features and business conditions. Essentially, there are two types of proprietary trading firms: recruiters and closed companies
- Proprietary trading firms, distinct from brokers or funds, do not manage third-party capital. Instead, they operate with their own money and do not accept external investments
- I will describe the different types of prop trading firms and explain how they make money. At the same time, I will also give an overview of the legal situation of prop trading providers in the USA and other important countries. Furthermore, I will highlight your advantages but also point out one or two risks
The Offer of Prop Trading Firms
The question of how a prop trading firm makes money can be answered very simply. A prop trading provider trades on the stock exchange using various financial instruments and earns its profits from it. The important point is forex prop trading firms always operate with their own capital.
The funds used are not special assets, i.e., not external capital. It is only correct to say that prop trading firms often have financial partners in the background who invest their funds in the company. The direct investments of these partners become equity capital.
However, prop trading firms do not conduct trades (investments) on the stock exchange themselves (or with their own employees). They use the expertise of specialists.
These specialists are the prop traders who work for the company and earn profit by leveraging market opportunities. Then, the generated profits are shared between the firm and the prop trader. The majority of prop trading firms focus on day trading activities. However, there are exceptions. Before getting started, you should always carefully read and understand the terms and conditions of the prop trading providers.
From the trader’s perspective, there are several points to consider when dealing with prop trading companies. These prop firms establish clear risk parameters that all traders must adhere to, such as daily drawdown limits and overall loss limits. Failure to comply with these limits will lead to disqualification from the program.
Types of Prop Trading Firms
My assessments of prop trading firms reveal that there are two types of prop firms, which I will briefly outline in the following sections.
Recruiters
The most well-known are the recruiter firms. The business model of these proprietary trading firms is designed to find new prop traders and train them in effective trading strategies. This makes it an accessible entry point for those looking to start a career in proprietary trading.
The trading firms provide customers with various account models to begin trading. Traders then undergo an evaluation phase, often supported by analytical tools, where they must demonstrate their skills. A fee is required, varying depending on the chosen account type.
Aspiring prop traders engage in trading on a demo account, simulating real market conditions while following the specific challenge rules. Their goal is to demonstrate consistent and sustainable profitability.
Upon proving their trading skills and ability to generate profits, they are granted a real-money trading account, with the prop trading firm providing the necessary capital. Some recruiter prop trading firms do not directly offer funded accounts; instead, they refer successful candidates to other companies.
A key aspect of the recruiter business model is training. A good prop firm offers traders learning programs, webinars with trading professionals, and many other forms of assistance.
A practical challenge arises regarding price data. During the evaluation phase, traders operate with “retail fees,” which are affordable and often waived by the firms. However, when executing live trades on the stock exchange, “professional fees” are required, which are considerably more expensive.
For professional and advanced traders, there are also some prop trading firms without evaluation. However, these are not very common.
Closed Firms
Closed prop trading firms focus exclusively on trading activities, attracting experienced traders. They are not interested in training prop traders but are always looking for professional traders who already understand their business.
Closed firms are relatively unknown to the public, and their operations differ significantly from those of recruiter firms. They do very little marketing. They provide their traders with access to markets that are normally closed to private traders.
Professional research access and improved trading conditions are also among the quality features of closed firms. Those who wish to partner with a closed prop trading firm must apply. They must provide appropriate references and a long, proven, and reliable track record.
How Prop Trading Firms make money
The financial performance of prop trading firms hinges on multiple factors, including the provider’s strategic direction. Recruiter firms earn a significant portion of their revenue from customer fees. It’s no secret that many aspiring traders fail in the initial evaluation rounds. These costs often have to be paid over several months before the qualification is completed. Subsequent trading on the stock exchange is then more or less a lucrative additional business for recruiter firms, backed by the insight gained from their evaluation processes.
Closed prop trading firms earn their money exclusively from profit splits. Professional, successful trading is clearly the focus. This approach allows prop trading firms to distribute gains among their traders while minimizing their own financial risk.
The top providers in the market pay their prop traders a profit share (commission) of 90% or even 95%. Since sometimes several thousand prop traders work for a firm, the companies generate their profit through the volume of traders. The more professional prop traders work for a provider, the more broadly the economic risk is distributed. Even if some traders do not land in the profit zone, the prop trading providers still have enough partners to ensure a positive balance.
If a prop trading provider files for bankruptcy, unpaid profit shares to prop traders (compensation) may be affected and included in the bankruptcy estate. However, as a prop trader, you are otherwise never involved in the company’s economic risk. You cannot incur any loss yourself.
Prop Trading Firms = Proprietary Traders
Legally, prop trading firms are always proprietary traders. Unlike funds, they do not manage special assets. The advantage for prop trading companies is that no financial regulatory approval is needed. So, prop trading providers are not regulated.
Collaboration with Brokers
Trades initiated by the traders are executed on exchanges through reputable brokers, enabling proprietary trading. While some prop trading firms publicly disclose their broker partnerships, others choose to keep this information confidential.
External financial partners are almost always involved in providing capital for the prop trading firms.
Starting your own Prop Trading Firm in the US: Legal or not?
Starting a prop trading company in the USA is legal. However, you need to follow certain regulations. Depending on your business model, you may need to obtain licenses from the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). If you only offer challenges, you won’t need any license. However, if you offer funded accounts, you’ll need a license to operate inside the USA.
In the US, trading Contracts for Difference (CFDs) is prohibited for retail investors. This means your prop trading firm cannot offer CFD trading.
Starting a small prop firm with basic technology and a limited number of traders might cost around $50,000 – $100,000. However, if it’s a big firm, the cost might reach a million US dollars.
Legal Situation in other Countries
In most Southern Hemisphere countries, the legal situation is comparable to the US. The laws are somewhat stricter only in UK, according to my experience. Here’s the situation for some of the important countries.
I looked at these countries:
Australia
Australia allows the establishment of a proprietary trading firm. However, there are several legal and regulatory considerations to be aware of. All businesses in Australia need to obtain an Australian Business Number (ABN) for tax purposes. You’ll need to follow the Corporations Act 2001, which outlines capital requirements, disclosure obligations, and director duties. Profits from proprietary trading are considered assessable income and are subject to income tax in Australia.
Canada
Establishing a prop trading firm in Canada is legal. If you’re only planning to use your own funds and won’t be managing client funds, the regulatory requirements are less stringent. Then, you wouldn’t need to register as an investment firm. You’ll also need to maintain a certain amount of capital to make sure you can cover potential losses and meet regulatory requirements. You must comply with various rules and regulations related to trading practices, risk management, anti-money laundering, and client protection.
Consult a CPA to understand the tax implications of earning passive investment income in a corporation before starting a prop trading firm in Canada.
New Zealand
New Zealand also allows you to start a prop trading company if you comply with the country’s regulations. You have to register with the Financial Markets Authority (FMA) as a Financial Service Provider (FSP). The firm may need additional lines, such as a derivatives issuer license, in exceptional circumstances. Firms must have AML/CFT procedures in place.
United Kingdom
If you’re trading with investor funds in a managed account program, you are doing a regulated activity. This means you need oversight from the FCA or a similar regulator. The most efficient way for new prop trading firms to become regulated is through an “umbrella company.” These companies already hold the necessary FCA permissions and can extend their regulatory cover to your firm for a fee.
This eliminates the need to apply for your own license, saving time and resources. Brokers can’t just invest money in any firm; they need to make sure whoever’s getting their rebates is playing by the rules. The umbrella service isn’t free. Expect to pay a monthly fee (£1,000-£2,000) and maybe even a cut of your broker bonuses (around 10-15%).
Advantages of Prop Trading Firms in the Anglo-American Region
You will find the majority of the best prop trading firms in the Anglo-American region. The reason for this is the “Independent Contractor” (IC) model.
An IC is a person associated with the company. They follow the company’s instructions and must adhere to clear guidelines, but they do not have an employment contract. ICs are used by many well-known firms in the USA, as well as in other economic sectors. In prop trading, IC traders are almost always used.
Like the US, Canada embraces the independent contractor (IC) model; however, the Canada Revenue Agency (CRA) keeps a closer eye on preventing misclassification of employees. Australia also makes use of the IC model, appreciating the flexibility and cost benefits it offers. It’s important for firms to ensure they adhere to Australian Taxation Office (ATO) guidelines.
In the UK, the IC model is quite prevalent, particularly in the financial services sector. However, companies must be well-versed in HMRC’s IR35 legislation to avoid penalties for misclassifying workers. Similarly, New Zealand supports the IC model. It has a strong legal framework in place, and the regulatory burden is less than that of full employment. To understand the laws better, you can also read our guide on prop trading taxes.
Some new prop trading providers are also based in the United Arab Emirates, as the laws there are comparable to those in the Anglo-American economic area.
How to find the Best Prop Trading Firm
If you are looking for the best prop trading firm for yourself, the first step should be to consider the company’s reputation and credibility. Additionally, check the challenge requirements in conjunction with the monthly costs.
For example, the current best prop trading firm (FTMO) refunds the monthly fee after a successful evaluation. Other crucial factors include profit sharing, trading instruments (Forex, stocks, futures, CFDs, commodities, etc.), advanced trading software, available trading platforms, and complemented by general quality indicators such as support, payment methods, or payout frequency.
You can find our comprehensive comparison with all explanations in our guide “Best Prop Trading Firms“.
Conclusion
In conclusion, it should be noted that prop trading firms engage in proprietary trading on the stock exchange. They do not conduct their trading themselves but work with external prop traders. To find successful traders for their company, these traders must go through an evaluation process or, in the case of closed firms, apply with the appropriate references. A recruiter prop firm is open to everyone, including beginners.
Prop trading firms make their money through customer fees and their share of profit splits, which are determined by the contractual agreement between traders and the firm.
Frequently Asked Questions
In the following question-and-answer section, I have compiled the most relevant details about prop trading firms for you.
Does a prop trading firm use its own or external capital?
A prop trading firm always uses its own capital. It does not manage external capital as special assets. Read more under “The Offer of Prop Trading Firms“.
What are the two business models of Prop Trading Companies?
The two business models are recruiters and closed firms. I introduce the two business models under “Types of Prop Trading Firms“.
Why are there so many prop trading firms in the US?
The US offers a favorable regulatory environment, deep capital markets, strong technological infrastructure, access to skilled talent, a culture of entrepreneurship, and potential tax advantages. Read why this is the case under “Starting your own Prop Trading Firm in the US: Legal or not?“.
Do Prop Trading Companies work with brokers?
Yes. Prop Trading Firms work with brokers who execute trades on the stock exchange. All information about this can be found in the section “Collaboration with Brokers“.
How does a Prop Trading Firm secure its trades?
The diversity of traders at Prop Trading Firms helps to secure their trades. The more traders work for a company, the higher the probability that they will collectively generate a profit. Additionally, there are clear daily and overall loss limits. Under “How Prop Trading Firms make money“, you can read how the companies achieve economic success.
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.
