How do prop firms make money? - TradeInformer (2024)

Since prop trading has blown up in the last couple of years, we get a lot of people asking two questions – how do prop firms make money and do they actually place real trades? Some people asking want to start a prop firm themselves. Others are usually liquidity providers that want to do business with existing props.

The short answer to these two questions is that props make most of their money from challenges. Some of them do also place real trades and generate money that way. But it is definitely not all of them. Why is that the case? Read on to find out or watch the video below.

How do props make money? Challenges

The main way that prop firms make money is from traders paying to take their challenges. FTMO, which is arguably the biggest company in the sector, has openly said that only about 10% of clients end up passing the challenge.

In some ways this is what you’d expect. Most brokers tend to see about 80% of clients lose money over a 12 month period. Challenges are shorter and the rules about what traders can do are far stricter – so you’d assume the proportion of people passing challenges would be smaller than those that are trading profitably with a broker.

Another factor to consider here is that a lot of people who do pass a challenge will still end up losing their account. This might be because they breach the rules within that account or just because they don’t trade profitably once they are given it.

The result is that even among traders that receive funded accounts, many do not end up making money or breach rules. So that means the other part of the business is not a guaranteed source of returns.

Another factor to consider here is that this is not like a ‘traditional’ proprietary trading company. Funded traders are not direct employees, who are coming to work every day, and getting a salary in return for generating profitable returns for the firm.

Even if they are profitable for a bit, they can ultimately blow up their account or breach the account rules, meaning they lose their funded account. So if you were thinking that, over the course of time, a prop firm would see a growing number of funded accounts, who in turn account for a growing proportion of overall revenues, that is not accurate.

Do prop firms make money from real trading?

This leads us on to the second area as to how prop firms make money – real trading. There is still a lot of murkiness around whether or not prop firms actually do place real trades. From what we see there is a level of nuance to this and it ultimately depends on the model a given prop firm is operating under.

So if you are wondering, do prop firms actually place real trades, the answer is some of them do but the majority don’t.

The reason that’s the case is due to how firms structure their funded account offering. We see three methods that prop firms are using to structure funded accounts, although there may be other variations on these out there.

A prop firm only offers demo trading

The most common model that we see today is that props only offer demo accounts and no real trades are ever placed. That is true for the challenges and the funded accounts that the prop is offering.

What this means is that any profits a trader with a funded account generates have to be paid for using the revenues produced by people taking challenges. Props have designed methods, like capping account sizes and profit share size, to deal with the risks of this model.

We think this is not a good model. If you are offering prop trading, there is an implicit assumption that you are offering real trading at some point. If you aren’t doing that, you aren’t a prop company, you are more like a casino.

And indeed, if you are running this model as a prop company, you could actually be subject to gambling regulations. What you are offering is effectively a skilled game with a payout – and this is regulated as gambling in many jurisdictions.

Claims that this is like a b-book broker model are misguided. A b-book broker has the regulatory approval to offer securities dealing services. Prop firms offering demo only trading operate under no equivalent framework. Brokers also have the ability to offset opposing positions and capture spread, using the margin that a loss making trader puts down to pay out profitable positions. Again, prop firms that never place real trades don’t have this.

Giving traders a brokerage account that the prop firm operates

The second method we see frequently is that a prop firm still puts its challenges on a demo account. But funded accounts are given an account, with ostensibly real cash, that is managed via a trading platform.

However, the key difference is that the platform is being operated…by the prop firm. This model is like a broker just giving someone a live trading account and then crediting it with some cash.

The result of this is that funded accounts are trading against the prop firm, rather than for it. While it may be the case that some props are just passing all this flow on to liquidity providers, there are no guarantees that is happening and it’s entirely plausible they are taking the other side of all trades. As such, this model bears a lot of resemblance to the b-book model.

This is arguably an even worse idea than the first method. Firstly, you are again misleading clients – what prop trading firm trades against its own traders?

Secondly, running a b-book – assuming the cash in the account is real – is a regulated activity. If you are based in a region where it is regulated, and you don’t have the requisite license, then you can end up with serious problems with the regulator.

Finally, assuming that the prop firm does just warehouse all of the trades it takes on, this means that no real flow ever hits the market. The prop firm is just taking the other side of it all.

The mirror trade model

The final model we see is kind of like a combination of the first two. A trader takes a challenge on a demo account. If they are successful, the funded account is still on a demo account.

The difference in this instance is that the trades a funded trader makes in their demo account are mirrored in a real money account managed by the prop firm. However, the caveat here is that not all trades will be mirrored.

This is due mainly to two factors. One is that some traders may have just got lucky when they passed the challenge. They may then be making reckless trades in the funded account that the prop firm won’t want to mirror with real money.

The other factor is managing the cumulative exposure of the prop firm. Some props may have thousands of funded accounts that are all active at once. Traders might, for example, take opposing positions. This leaves something of a conundrum for the prop firm – one of the traders has to be right, but if they take both positions, they will be effectively flat or even loss-making, due to trading costs.

Do prop firms place real trades?

As all of this suggest, some prop firms do place real trades in the market. But at the time of writing, the large majority of prop firms appear to not do that. They either just offer pure demo trading and payout trader profits from people taking challenges. Or they just warehouse everything with a model that is very similar to a b-book broker.

Props that do mirror trades from demo-operated funded accounts will not copy every trade those accounts make in the real market. Doing so would create a level of risk that props do not want to take on.

How do prop firms make money? - TradeInformer (2024)


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