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Unlocking The Potential of Proprietary Trading: A Comprehensive Guide

Pavel Satsuk Soft-fx
Written by Pavel Satsuk
Head of Business Development at Soft-FX Dev

Introduction

First, what is prop trading? Proprietary trading, also known as “prop trading”, is a unique style of trading in the financial market. It occurs when financial firms or a group of traders use their capital to invest directly in the market and make gains. With these investments, they can make gains rather than earn commissions from trading on behalf of others. Popular instruments traded by prop firms range from stocks, bonds, currencies, and commodities, to other financial instruments. Pop traders are individuals who are employed to use their market insights to trade these assets to generate profit for the firm.

This form of trading is different from the conventional form of trading. To be honest, it is quite different from the traditional method of trading. Traditionally, orders were always placed through brokers, who executed each order to earn a commission. These brokers acted as intermediaries between the market and investors. However, the pop trading style is quite the opposite, prop firms do not earn commissions. The firm itself is the investor, and it uses its funds to trade. Pop traders do not generate commissions, instead, they trade to exploit market opportunities and maximize the firm’s capital.

Another unique characteristic that sets pop trading apart from traditional trading is the inherent alignment of risk and reward. Pop traders’ compensations are proportional to the performance of their trades, they do not earn a commission on every trade like brokers. The common compensation model among pop traders is the profit-sharing model. With that, a percentage of the profits from successful trades is earned by the pop trader. This is known to incentivize them to make better trading strategies for the most optimal returns. It is important to note that the losses incurred by the traders also affect their compensation. This risk-reward alignment has been known to motivate traders to trade more efficiently and foster accountability.

The Evolution of Proprietary Trading

Prop trading is not exactly a new style of trading, its history dates back even to the beginning of organized financial markets. Banks and other similar financial institutions engage in prop trading by using their capital to facilitate market liquidity and leveraging short-term price changes. However, there were constraints on pop trading activities by regulatory authorities, which limited them.

However, in the late 20th century, everything changed for prop trading. New technologies were introduced which led to the use of algorithms and advanced-tech computers in prop trading. One popular strategy that came alongside this new technology was the High-Frequency Trading (HFT) strategy. It helped prop firms leverage market inefficiencies to make better trades by faster order placement and execution.

One important spin-off effect of the technological transformation of pop trading is the democratization of pop trading opportunities. Technology has aided in the development of advanced trading platforms and readily available market data. This has encouraged the growth of online prop firms and has provided individual traders with insufficient capital access to trading opportunities. It’s a synergistic relationship and a win-win situation. Prop firms can equip new traders with access to better trading technology, educational resources, and capital for trading, and then the prop traders help generate more profit for the firm and maximize the its capital.

Benefits of Prop Trading

For young and aspiring traders, prop trading is a lucrative avenue for displaying their skills before going independent. They also enjoy other benefits like:

  1. Access to trading capital: One of the major benefits of becoming a prop trader is the accessibility to more trading capital. Traders do not need to trade with personal funds, and their trades are fully funded by prop firms. This helps prop traders leverage market opportunities that might be inaccessible with smaller capital to generate better ROI.
  2. Utilization of Advanced Technology: Due to the huge capital accessible to prop firms, they can invest heavily in sophisticated trading platforms and tools. These platforms can provide real-time data analysis, advanced charting tools, and sophisticated order execution. Examples of these technologies are real-time market data feeds, algorithmic trading tools, advanced charting software, and so on. These technologies give prop traders the advantage of making informed decisions and reacting swiftly to market movements.
  3. Supportive Education and Mentorship Programs: Many prop firms offer learning and mentoring programs to help aspiring traders gain the right knowledge and skill set for prop trading. The traders are exposed to technical analysis, fundamentals, risk management, the psychology of trading, and any other relevant knowledge to ensure their successful careers.

Different Prop Trading Styles

There are different instruments that can be prop traded, each of them with their unique opportunities and challenges. Some of them are:

Foreign Exchange (Forex) Trading: The forex market is the world’s largest financial market, handling trillions of dollars in transactions daily. Prop forex traders use this market to take advantage of short-term price movements in currency pairs.

Unique Opportunities in the Forex Market:

  • It is highly liquid so prop traders can enter and exit positions with minimal slippage
  • It is a 24-hour continuous market.

Challenges:

  • The market is highly volatile— prices can change quickly at any time
  • Many prop firms offer leverage for forex trading. This leverage is tricky because it can magnify both the profits gained and losses incurred. Therefore, the trader has to be skilled to manage the leverage.

Cryptocurrency Trading: Prop crypto traders can also take advantage of price movements in digital assets like Bitcoin, Ethereum, and so on.

Unique Opportunities

  • It is a highly volatile market so skilled prop traders can take advantage of rapid price changes to make quick gains.
  • It is an emerging market so prop traders can establish their position at the forefront of this market.

Challenges

  • The regulatory environment of crypto is still evolving and uncertain.
  • Cryptocurrencies have a shorter historical record.

Futures Trading: Prop futures traders use futures contracts to speculate on price movements and hedge existing positions.

Unique Opportunities

  • The contracts offer leverage, which can be used to control a larger position with a smaller capital and then magnify potential profits.
  • The contract can also be used to hedge against potential losses in other assets, serving as a valuable risk management tool.

Challenges

  • There are some specific margin requirements that prop traders must meet before they can hold a futures contract. This can be costly for the traders.
  • Futures contracts expire, therefore, prop traders must develop effective strategies to manage their trade positions before expiry dates.

Options Trading: Prop options traders use options trading to capitalize on price movement and volatility to hedge their existing portfolio holdings.

Unique Opportunities

  • It is useful for generating income
  • It can also be used to hedge existing  positions and mitigate potential portfolio losses

Challenges

  • Options trading is not very straightforward, it requires an understanding of options pricing models
  • The value of options contracts also declines over time due to their expiration dates.

Operational Mechanics of Proprietary Trading

In this section, we will discuss how proprietary trading works. We will discuss the evaluation process for aspiring traders, profit-sharing arrangements, drawdown limits, and risk management protocols.

Evaluation Process For Aspiring Traders

Before prop traders are allowed to trade, the prop firms ensure that the traders undergo an extensive evaluation or testing process. This evaluation process helps them select skilled traders, among others. The assessment may involve written and oral exams that test theoretical knowledge of the financial markets and risk management principles. It may also be in the form of psychological assessments or scenario-based simulated trading challenges where traders make trading decisions in a simulated environment. This kind of assessment tests the trader’s skill as well as how they manage risk and trade under pressure.

Profit-sharing Arrangements

There are different profit-sharing models used by prop firms for their prop traders. The two most common models are the shared profits and performance-based compensation. The prop firm can either choose to pay the prop trader a predetermined percentage of the profits generated or performance-based compensation. With performance-based compensation, profit sharing can be tiered, and prop traders who pass the performance targets become eligible for a higher share of the profits.

Drawdowns

Drawdowns are tools used to limit losses made by prop traders and protect their capital. A dropdown limit is the maximum amount of capital a prop trader can lose before the firm limits further trading activity on the account.

Risk Management Protocols

Prop trading firms typically implement some risk management protocols and guidelines to mitigate potential losses and promote responsible trading. Common risk management practices by prop firms include position sizing, stop-loss orders, and risk monitoring.

Who Can Become a Prop Trader?

Some of the necessary skills for individuals who want to become prop traders are:

  • Analytical skills
  • Quantitative aptitude knowledge
  • Technical knowledge
  • Computer Literacy

Beyond these skills, a successful prop trader must also possess some strong mental and psychological attributes such as:

  • Ability to analyze data objectively and translate insights into actionable trade strategies
  • Emotional discipline and maintaining composure under pressure.
  • Market understanding

It is important to note that success in prop trading is not defined by background, the industry is very inclusive. While an educational background in fields like Finance and Economics is advantageous, anybody can still become successful without such a background. A successful trader is defined by willingness and passion to learn and upgrade one's knowledge and skills.

Risks Involved In Prop Trading

Like every other form of trading, prop trading has risks that are inherent to its system. Individuals aspiring to be prop traders must be fully aware of the challenges they may face while prop trading— financial and physical challenges. This knowledge will assist them to develop strategies to mitigate these challenges.

Financial Risks Involved in Prop Trading

Some of the most common financial risks in prop trading are:

  • Market volatility, which can lead to significant losses if traders do not implement effective risk management strategies.
  • The leverage offered by prop firms to traders can also magnify their losses the same way it magnifies profits. This means that prop traders have to learn the necessary skills and risk management strategies to navigate a leveraged trade situation.
  • Prop traders can also experience drawdown which occurs when the traders incur losses on a series of trades and consequently their account balance falls below a certain threshold. Drawdowns can lead to prop firms restricting the trading activities of the traders or even outright terminating their employment.

Psychological Challenges of Prop Trading

  • Pressure to constantly generate profit can lead to impulsive and poor trading decisions.
  • Fear of losses can cloud the trader’s judgment, leading to doubts, missed opportunities, and poor decision-making.
  • The constant pressure on a prop trader, combined with fear of losses, can lead to serious emotional stress.

To mitigate the challenges involved in prop trading, traders need to maintain discipline and emotional stability. Traders should ensure to:

  • Adhere strictly to their trading plans
  • Implement effective risk management techniques
  • Maintain a healthy work-life balance
  • Incorporate mental fortitude training into their routines

Choosing the Right Prop Firm

Prop traders need to partner with reputable and well-established firms. Here are some key factors to consider before choosing a suitable prop firm to partner with:

  • The reputation and history of the firm including the track record of their prop traders, reputation on ethical practices and staff welfare, industry recognition, client testimonials, and so on.
  • Transparency of the firm’s operations in terms of profit-sharing models, fee structures, risk management protocols, and so on.
  • Licensing and regulatory compliance with relevant authorities
  • Profit sharing model and rate of compensation for performance
  • Support services are available such as training programs, mentorship opportunities, and technology systems.

Preparation For a Career in Proprietary Trading

To prepare yourself for a successful and thriving prop trading career, you should consider enhancing your education and skills in the following areas:

  • Fundamentals of financial markets
  • Technical analysis
  • Quantitative skills
  • Proficiency in the use of popular trading platforms

It is also important to stay updated with the latest market trends. Staying updated helps traders leverage upcoming trends. Here are some important avenues for staying informed on market trends:

  • Financial webinars and conferences
  • Financial podcasts and online video platforms
  • Financial news websites and blogs
  • Industry research reports

If you have studied widely the skills needed for prop trading as well as the market, it is important to develop a detailed trading strategy. A detailed strategy is a catalyst for success as a prop trader. To develop a robust trading strategy, you should:

  • Identify your trading style based on your preferences, i.e., do you prefer short-term trades to long-term trades?
  • Use historical data to test your current trading strategy for its effectiveness. This technique is called backtesting, and it helps identify the strengths and weaknesses of trading strategies.
  • Practice your trading strategies with a paper or demo account to trade in the real market without risking real funds.
  • Seek mentorship and guidance from experienced traders

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FAQs

Q1: Can I engage in prop trading as a side hustle?

Prop trading usually requires a full-time commitment, however, some prop firms may offer flexible arrangements depending on their needs.

Q2: Are there any hidden fees in prop trading?

Reputable firms typically outline all the possible fees clearly in their agreements or contracts. However, you might encounter costs like:

  • Inactivity fee
  • Platform subscription fee
  • Evaluation fees

Q3: What is the typical profit split in prop trading?

The profit split depends on the profit-sharing model of the prop firm. However, common split percentages are 70% to 30% (70% for the firm, 30% for the trader), and 50% to 50%.

Other firms employ tiered structures where prop traders are compensated based on their performance, and higher-performing traders receive a higher share of the profits.