Prop Trading 101 – The What, Where’s and How’s

Prop trading isn’t a new concept but it is one that’s getting a lot of exposure with more and more firms entering the market with their own version and platforms.

The number of brokers operating prop trading accounts is also rising as operators see the practice as an efficient way to attract top traders to their environments which in turn means more trading volume and brokerage fees.

In this article we’ll take a look at the concept of prop trading, where it happens, how it works and what you need to get started. Let’s dive right in!

What is Prop Trading?

Prop trading, or proprietary trading to give it its full name, is a form of trading where individuals or firms trade financial instruments using their own money or capital instead of clients’ funds. In prop trading, the firm or individual is both the trader and the owner of the capital being used for trading. This distinguishes it from traditional trading, where traders use their clients’ capital to execute trades.

Defining Prop Trading

Prop trading involves traders or financial firms using their own capital to speculate on various instruments to generate profits. These instruments could be currencies, stocks, bonds, commodities amongst others. Rather than executing trades for clients, prop traders trade on their own behalf, using their own funds and strategies.

Types of Firms

Proprietary trading firms fall into various categories based on their strategies and focus. These include:

Market-Making Firms: These firms provide liquidity to the market by quoting bid and ask prices on various securities. Market-makers profit from the bid-ask spread and aim to maintain a balanced book.

Statistical Arbitrage Firms: These firms use statistical models and algorithms to identify pricing inefficiencies in the market and take advantage of them. Arbitrage employ complex quantitative strategies to generate profits.

High-Frequency Trading (HFT) Firms: As the name implies, HFT firms engage in high-frequency automated trading, looking to take advantage of small price movements and executing high volumes of trades. HFT firms rely on advanced technology and sophisticated algorithms.

Event-Driven Firms: These firms focus on trading around specific events, such as mergers and acquisitions, earnings releases, or regulatory announcements. Event driven firms aim to profit from the price movements triggered by these events.

Each type of prop trading firm has its own set of strategies and risk management techniques, allowing traders to specialize in their preferred trading style.

In the world of retail trading, the term prop trading has taken on a more specific definition. Trading firms and brokers offer funded accounts to traders who pass specific trading challenges.

These challenges increase in complexity which is reflected in the level of funding on offer to successful traders.

Passing the first challenge for example may qualify for a funded account of say $10,000 while passing higher challenges could qualify for a funded account of $100,000 or more.

These challenges come with a set of variables traders have to meet during the initial evaluation stage. These variables include targets such as profit targets and maximum drawdown. Depending on the levels, traders get a share of the profits they generate ranging from 50% to 80% on higher account levels.

Each challenge level comes with a corresponding registration fee, payable by the trader to the firm or broker. These range from under $100 on lower account levels to over $1,000 on higher account levels.

The parameters of each challenge tend to vary with the type of financial instruments. Trading CFDs will have different parameters than trading futures for example. That however is up to the individual firm or broker.

Starting with a prop firm or broker follows a fairly uniform procedure. Traders sign up with the company, decide on which asset class and they want to trade, choose their preferred trading platform and the challenge level and begin the evaluation stage with their own trading strategies.

Traders who pass the evaluation stage then move on to live trading, during which they are entitled to a percentage of their generated profits.

Typically, with prop trading firms, accounts for evaluation phases and initial funded phases are traded in a simulated environment, operated through a bridge to offer the same conditions as a live account. This replicates live trading conditions in the simulated environment.

Once traders prove their track record and ability to generate consistent profits, trading moves to funded live accounts.

The whole concept relies on advanced technology to control the trading side and the challenge and evaluation stages.

Trading conditions change depending on the levels traders reach. Monitoring these levels and the trades involved calls for complex automation to carry out all the necessary operations. Typically, brokers rely on Fintech companies like PLUGIT to provide the necessary technology for prop trading.

PLUGIT has been the technology provider of choice for many leading global brokers. Our prop trading solution has moved into the final testing stages, and the initial results have far exceeded expectations.

Client feedback is always something we consider carefully here at PLUGIT, and we’ve taken suggestions onboard for changes and upgrades to the platform.

Slated for release later during the year, our prop trading solution will be the next addition to our multi-award-winning YOONIT brokerage solution.

Make sure to check back regularly and be on the look out for a new player in the world of prop trading solutions as we move to a final release!

Prop trading regulations will depend mainly on the particular firm’s regulatory framework.

Firms that only operate prop trading programs have different restrictions to brokers, for example, who offer prop trading as part of a broader range of services.

Regulation has been in the news recently, with concerns mainly centering on US clients. This also involved providing accounts to US clients through firms using grey Metatrader licenses.

As with anything in the financial markets, regulations evolve and change. Brokers offering prop trading do so within the framework of their regulation. Prop trading firms depend on a broker to provide services to their clients with the associated regulatory restrictions.

Brokers offering prop trading directly do so within the framework of their regulation. Regulation will change and adapt, but the concept certainly looks to be here to stay.