Proprietary trading profit and loss distribution is a key part of the relationship between traders and the firms they work with. Prop trading firms are financial institutions that allow traders to trade with the firm’s capital.
These arrangements usually involve a profit split where traders and the firm share the profits of the trades, usually according to an agreed upon contract. While profits are shared, losses are usually borne by the firm only, so individual traders are not exposed to risk beyond their control.
The profit split percentage varies by firm but usually the trader keeps a large majority of the profits. This aligns the interests of the trader and the firm: both want to pursue winning strategies as their interests are tied, but the trader doesn’t have the added stress of personal risk.
The agreements and structures account for things like trader performance, market conditions and the amount of capital provided by the firm.
Summary
- Prop firms share profits with traders but absorb all losses.
- Profits are usually split in favor of the trader, 80/20 is a common split.
- The profit and loss distribution agreement accounts for multiple things, performance and capital provided.
Profit and Loss Distribution Basics
When you trade with a proprietary trading firm, or “prop firm”, the profit and loss distribution is pre-agreed. This is a key part of aligning your interests with the firm.
Profit Sharing: You, as a trader, get to keep a percentage of the profits from the trades. The percentage you get depends on the agreement which can vary greatly between prop firms. Some common profit splits are 50/50, 70/30 or even 90/10 in favor of the trader, reflecting the level of firm support, resources and risk.
Loss Allocation: When it comes to losses, prop firms absorb them as long as you follow the agreed upon trading strategies and risk management parameters. But you need to know that if you deviate from the trading guidelines, you might be responsible for the losses.
- Capital Contribution: You may need to put up some capital to join the firm. This “skin in the game” aligns your risk with the firm’s.
- Risk Management: Firms have strict risk management protocols in place to protect their capital and sustainability.
Remember, the profit and loss distribution terms are usually outlined in a legal document when you join the firm. Make sure you understand and agree to these terms before you join to avoid any surprises later. Always read the contract and ask questions if you don’t understand something.
Trader and Prop Firm Agreements
In prop trading, your earnings and losses are governed by specific agreements. These documents outline how you share profits with the prop firm and how losses are handled.
Profit Sharing Models
Fixed Percentage Split: The most common is where you as a trader get a fixed percentage of the profits. For example, if the split is 70/30, you get 70% of the profits and the firm gets 30%.
- 70/30 Split Example:
- Your Profit: 70%
- Firm’s Share: 30%
High-Water Mark Structure: Sometimes a high-water mark applies where you make profits above the highest peak your account has reached before profits are split.
- High-Water Mark Principle:
- Profit Calculation: Above previous peak
- Your Share: As per agreement after high-water mark
Loss Absorption Protocols
Trader-Firm Agreement: Losses can be absorbed by the firm, by you or a combination of both. This is usually outlined in your contract.
- Absorption Examples:
- Firm-Only: Losses are firm’s responsibility.
- Shared: Losses are split as per the agreed split.
Drawdown Limit: To limit losses, your trading may be subject to a drawdown limit—a threshold if breached may suspend your trading or modify profit sharing.
- Drawdown Policy:
- Limit: Percentage or dollar amount
- Action: Trading halt, strategy reassessment or modified profit shares
Distribution Factors
The profit and loss distribution between trader and prop firm is influenced by several key factors. Knowing these will help you understand what to expect in such a relationship.
Trader Performance
Your performance as a trader is a key factor in profit and loss distribution. Generally, the better you perform, the more you get of the profits.
Prop firms have a merit based system where high performing traders get a larger percentage of the gains and poor performance may result in a smaller share or even penalties.
Market Conditions
Economic trends and market volatility can impact the distribution agreement between you and the prop firm. During volatile market conditions, risks are higher and so profit sharing ratios may be adjusted to reflect the increased risk taken by the firm. In stable market conditions, profit and loss distribution is more predictable and standard.
Firm’s Policies
The internal policies of the prop firm you trade with also impact profit and loss distribution. These are usually outlined in the contract and can be fixed ratios, performance benchmarks or graduated scales based on trading milestones. Make sure you understand these as they affect your take-home pay.
Distribution Structures
In prop trading, your compensation is performance based. Knowing how profits and losses are split between you and the prop firm is key to calculating your earnings.
Pure Profit Split
In a pure profit split model, you share profits with the firm as per the agreed upon terms. For example, a common split is 50/50 but you may see 60/40 or 70/30 in favor of the trader or the firm depending on the firm’s policy and your level of experience.
Salary + Bonus
The salary + bonus structure provides a base salary so you have a stable income. You also get a bonus based on performance metrics. The bonus is usually a percentage of the profits you make above a certain threshold so you are incentivized to outperform.
Draw Against Profits
A draw against profits arrangement is a regular payment like a salary. This payment is then deducted from your profit share.
If you make more profits than the draw at the end of a period, you get to keep the excess. If not, you may owe the firm a balance depending on the agreement.