Prop Firms Guide

Prop firms are hugely popular among retail traders, whether in Forex, futures, or other asset classes, and these days, I get asked about prop firms as much as any other trading question.

In this guide I’ll explain what prop firms are, why they’re popular, how to choose them and the challenges and risks that using a prop firm can entail.

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What Are Prop Firms?

Prop Firms Profit-share with Traders

A proprietary trading firm, or “prop firm” for short, is an entity that allocates capital to other individuals to trade. In exchange, the trader receives a percentage of the profits they make trading the firm’s capital. This profit-sharing model is the reason why people work with prop firms.

Traditional vs. Online Prop Firms

There are two distinct styles of prop firms: traditional prop firms vs. online prop firms. Traditional prop firms require the traders to be physically present at the prop firm’s offices. Sometimes, they pay a salary to the trader in addition to a portion of the trading profits. Not many traditional prop firms exist today, but many larger cities, such as New York City and London, have traditional prop firms.

An online prop firm (sometimes called a “modern prop firm”) allows traders to operate from nearly anywhere in the world. Almost all online prop firms require traders to pay a fee for an evaluation test or “challenge” to see if they are profitable before the prop firm will allocate capital. I will focus on online prop firms in this article.

Why Are Online Prop Firms Popular?

Prop firms create low barriers to entry to access external capital to trade. Anyone in the world, in any time zone, can apply to prop firms. The evaluation or challenge fees are often low enough that most people can afford them. Most importantly, individuals do not have to give up other parts of their lives, such as jobs or family responsibilities, to trade for prop firms, as long as they can pass the evaluation test or challenge.

How Do Prop Firms Work?

A prop firm's business model is to find skilled traders to trade for the prop firm. Prop firms make money by keeping a percentage of the profits the traders generate on their capital and collecting fees from the evaluation or challenge test.

Each prop firm will have different rules for its challenges. The most important aspect for traders is understanding how each prop firm's challenge rules work. Let’s look at the most common features for challenges.

Prop Firm Challenges

Before a prop firm offers a profit-sharing account to someone, it must know whether they can trade profitably. They do this through a “challenge,” where applicants trade a monitored demo account. The rules of the challenges will vary between prop firms, but here are the most common features:

1. Challenge fee. This can vary from a few hundred dollars to a few thousand dollars. Often, a prop firm will offer different fee levels from which to choose. The higher fee levels give access to higher account sizes after the trader passes the challenge.
2. Phased or tiered challenges. Some prop firms split the challenge into two phases or tiers to further verify a trader’s skills.
3. Trading environment. The prop firm will specify which trading platform, markets and leverage ratio traders can use.
4. Profit target. To pass the challenge, the prop firm will require the trader to grow the account by a minimum percentage of the initial (demo) balance.
5. Maximum daily loss. The prop firm will set a maximum daily loss percentage. If the trader hits this level, they must cease trading for the day. Some prop firms will use only the value of closed trades, and others will use the value of closed and open positions.
6. Maximum account loss. If the trader hits a maximum loss percentage from the initial balance, the challenge stops, and the trader must start again. It often means paying the challenge fee again. Some prop firms will use only the value of closed trades, and others will use the value of closed and open positions.
7. Minimum and maximum metrics. Some prop firms require the applicant to trade a minimum number of days, execute a minimum number of trades, and complete the challenge within a maximum time limit.

Profit Split After the Challenge

Once the person passes the challenge, the prop firm will provide an account from which they receive a percentage of the profits. Some prop firms use a live account with real money, while others give the trader another demo account, but will still pay out cash profits. The percentage the trader receives of their profits can range from 50% to 90%.

Benefits of Prop Firm Trading

These are the top benefits of using a Prop Firm:

1. Access to capital without risking personal funds. After passing the challenge, prop firm account sizes can range from $10,000 to $200,000 and more. Many individuals may not have access to these amounts in their personal funds, or even if they do, may not be able to risk it in the markets. Prop firms can fast-forward trading careers by giving individuals access to capital they may not otherwise have.
2. High leverage opportunities. Many prop firms allow trading high-leverage instruments, such as Forex and futures contracts.
3. Profit-sharing models that reward performance. Prop firms align their interests with yours by instantly rewarding good performance.
4. Support through mentorship programs or trading tools. Established prop firms offer mentoring from trading psychologists and other successful traders and make available cutting-edge tools they know their other traders have used to generate profits.
5. Risk management. Prop firm’s risk management rules help protect traders from devastating losses, which is a significant reason why many independent traders lose money.

Challenges and Risks

1. The evaluation fee is the primary financial risk for someone applying. It’s usually refundable after successfully completing the challenge. However, most prop firms require traders to pay the challenge fee each time for multiple attempts.
2. It’s easy to fail the challenge by hitting the maximum drawdown limit, especially if the prop firm includes the value of open trades in the drawdown.
3. Risk of losing access to funded accounts due to rule violations. Many prop firms do not allow traders to use third-party automated trading algorithms or signal providers. It may be hard for them to detect if you do that. However, if they find you are breaking this or other rules, they often terminate the agreement immediately.
4. Potential scams or unreliable firms. The prop firm industry reminds me of the early days of Forex when the industry felt lawless. For example, some prop firms require traders to use brokers that manipulate the execution so that they get poor fills and are less likely to pass the challenge.

How To Choose the Right Prop Firm

Because prop firms are largely unregulated, there are vast differences in the quality of firms, making research essential before selecting a firm. Here is what I look for when choosing a prop firm:

1. Reputation and reviews from traders: Very few firms have 100% positive reviews, but checking reviews can point to a pattern of recurring negative or positive issues. For example, does the prop firm have a reputation for paying out regularly? Do traders complain about the fills with the broker that the prop firm uses?
2. Trading rules. Ensure the challenge rules are realistic for your trading style: For example, can you hold overnight or weekend trades if that is part of your trading strategy? Can you have multiple open positions in the same instrument?
3. Different rules after passing the challenge: For example, the challenge might allow overnight positions, but the funded accounts do not. Ensure that any rule changes for funded accounts are suitable for your trading.
4. Evaluation fees and refund policies: The fees should be reasonable and refundable upon passing the challenge.
5. Profit splits and payout frequency: Payouts have become more generous in recent years, and I frequently see payouts up to 90% from some prop firms, with on-demand payouts.
6. Trading instruments offered (e.g., Forex, commodities, indices): Ensure the prop firm allows you to trade the range of instruments you typically would trade.
7. Customer support quality: Reviews often reveal the quality of customer support. You can also contact the prop firm with basic questions or ask to speak to someone, which will indicate the level of customer support.

Tips for Success in Prop Trading

1. Have a complete strategy before beginning a challenge. A full strategy consists of entry, stop-loss and take-profit rules.
2. Practice on a demo account before entering the challenge—prove to yourself first that you can comply with the prop firm’s rules.
3. Focus on risk management to avoid violating rules. Prop firms take risk management rules very seriously, especially the maximum drawdown rules. Before embarking on a challenge, know your position sizing so you do not exceed these limits.
4. Discipline. Discipline. And more discipline. Successful trading requires following the rules. I review my trading daily and use a journal to help maintain my discipline.

Glossary

Evaluation

An evaluation defines the period during which a prop firm will assess the trader and their trading strategy to ensure compliance with the rules set by the prop firm. While most have no time limits, they all require traders to reach profit targets while adhering to strict trading rules. Violating the rules results in a failed evaluation, and traders must pay the evaluation fee if they wish to participate in another evaluation challenge.

Evaluation Fee

Most prop firms charge a one-time evaluation fee based on the size of the desired funded account, the evaluation type, and potential add-ons. Please note that you cannot change the size of the funded account once you have paid the evaluation fee. Therefore, if you pay for a $25,000 account evaluation, the funded account will be $25,000.

1-Step Evaluation

A one-step evaluation requires traders to reach the profit target once, without violating the rules. One-step evaluations have the highest profit target requirement, and traders must usually earn 8% to 10% to qualify for a funded account. Evaluation fees are generally the highest for one-step evaluations.

2-Step Evaluation

A two-step evaluation often requires reaching a higher profit target during the first step, for example, 8%, followed by a smaller profit target during the second step, like 5%. The evaluation fees for two-step evaluations are smaller, but traders must wait longer to qualify for a funded account.

3-Step Evaluation

A three-step evaluation is the rarest evaluation model, but it typically incurs the lowest evaluation fee. Most prop firms ask traders to achieve the same profit target during each phase, and it is generally smaller than other evaluation types, for example, 6%.

Consistency Rule

Some prop firms require traders to comply with a consistency rule, or to achieve a minimum consistency score. This will cause most funded traders to lose their account access, as markets are constantly shifting, and the consistency rules are usually restrictive. Prop firms usually require a level of consistency, near the high-water mark of the portfolio, with a narrow band of acceptable losses. No trader can achieve consistent performance on all trades, as markets are dynamic.

2% Rule

Some prop firms have a 2% rule, which states that no single loss can exceed 2% of the portfolio balance. 2% on a $25,000 portfolio is a maximum loss of $500 per trade. A violation of the 2% rule could result in a hard breach and the loss and closure of the account.

Maximum Daily Drawdown

The maximum daily drawdown refers to the maximum loss a prop trader is permitted during the trading session. For example, if a trader has a $25,000 account and the maximum daily drawdown is 4%, the total permitted loss is $1,000. A higher loss will result in a soft breach or a hard breach of the trading rules, depending on the prop firm. A hard breach will result in the cancellation of the funded account.

Maximum Drawdown

The maximum drawdown is the total loss a trader can incur before a hard breach

results in the cancellation of the account. Prop firms either have a maximum drawdown based on the starting balance of the portfolio or a trailing maximum drawdown based on the account's starting balance each trading day. For example, a maximum drawdown of 10% on a $25,000 portfolio is $2,500, meaning the traders will lose access if the account drops to $22,500. The same applies to a trailing maximum drawdown, except that the balance is the starting balance of the day, and it cannot decrease below 10% of the starting balance.

Minimum Trading Days

Prop firms with minimum trading day requirements require traders to place trades for as many days as they specify. This only applies to evaluation accounts and not to funded traders. For example, a prop firm with a minimum trading day requirement of five days wants to see the prop trader placing trades for at least five days. It forces traders to trade for multiple days and follow trading rules rather than achieving the profit target in one session or with just a few trades.

Monthly Subscription

A few prop firms forego evaluations and grant access to funded accounts via a monthly subscription. This is a more expensive model, and prospective retail traders should carefully consider the costs and calculate the minimum profits required to break even. Monthly subscriptions usually lower the profitability for traders.

Payout Period

The payout period determines how often traders can request a payout. Many prop firms allow monthly withdrawals, but bi-monthly payout periods are widespread among the most reputable prop firms. Some prop firms allow traders to purchase an add-on to enable weekly payout periods.

Profit Split

The profit split is the percentage that traders receive as withdrawable profit. An acceptable profit split is 80%, but the best prop firms usually grant 90% or 100% via add-ons. For example, if a trader earns $1,500 during the payout period, and the prop firm offers a 90% profit split. It will result in a withdrawable profit of $1,350 for the trader.

Profit Target

A profit target typically applies only during the evaluation process. Prop firms require prospective traders to demonstrate their strategy and earn a set percentage before they can pass to the next evaluation phase or receive a funded account. Profit targets rarely exceed 10% of the portfolio or $2,500 on a $25,000 evaluation account.

Add-Ons

Many prop firms allow traders to purchase add-ons during the checkout phase. These can raise drawdown levels, increase the payout frequency, enable restricted trading strategies, or enhance the trading environment via other improvements.

Hard Breach

A hard breach refers to a violation of trading rules that will result in the termination of the portfolio. They often include breaching the maximum drawdown or the use of restrictive trading strategies.

Soft Breach

A soft breach of trading rules is a violation of the prop firm’s trading rules. As it is “soft”, traders are given the chance to correct it. It may result in a warning, but never in a portfolio loss unless the prop firm has a set tolerance level for the number of soft breaches a trader can trigger. Some prop firms may deploy software to correct soft breaches.

Instant Funding

Instant funding refers to prop accounts that require no evaluation. Prop traders must pay a one-time fee, but it can be notably higher than evaluation-based alternatives, often two to five times higher. After the prop firm receives the payment, prop traders can start earning immediately. They should also evaluate the trading rules, which could be stricter than evaluation-based accounts.

Scaling

The best prop firms have a scaling program that allows traders to increase their portfolio size if they meet the parameters. In rare cases, it can also unlock a monthly salary. Most scaling programs focus on allowing traders to manage more demo capital, increasing their earnings potential. It can also include an increase in daily and maximum drawdown levels or a higher profit share.

Stop-Loss Requirement

Prop firms with a stop loss requirement require traders to place a stop loss with each trade. Most prop firms advise traders to use a stop loss, but do not make it a requirement. Those prop firms that do make it a requirement may cancel orders or delete trades without a stop loss. This will also result in a soft breach of trading rules.

Conclusion

Many successful traders never use a prop firm. However, depending on your circumstances, a prop firm can close the gap by providing access to larger account sizes. If I had a personal $5000 account versus a $50,000 prop firm account, I could be ten times more successful with a prop firm account. However, prop firm trading has rules that may require me to adjust my trading. Prop firms vary in quality, and unfortunately, some are dishonest. Research the firms and ensure their rules fit your trading style. Under the right conditions, prop firms can launch your trading career.