Proprietary trading firms are a special thing in the financial industry. They provide a platform for traders to trade with the firm’s money.
Unlike traditional investment setups that handle client funds, prop firms invest their own money. The focus is on the skills of the trader.
These traders may not have big capital but have the skills to make money in the markets. Prop firms use a mix of strategies from day trading to complex derivatives trading.
Capital is not free. Traders go through a rigorous evaluation process, some prop firms charge a fee for this evaluation.
Once in, traders can trade with the firm’s capital under certain conditions. The firm’s revenue then comes from a share of the profits made by these traders.
Key Points
- Prop firms provide capital to skilled traders, share in the profits.
- Traders are evaluated before getting access to firm’s resources, some firms charge evaluation fee.
- Firms use various trading strategies to make money without managing client funds.
Revenue Streams
In the world of proprietary trading firms, or prop firms, your revenue comes from a few main streams. Each stream is important to the overall profitability of your firm.
Direct Trading Profits
Your firm trades in the markets, buys and sells securities. The goal is to buy low and sell high. The profits from these trades are your income.
- Buy Low, Sell High: Exploit market inefficiencies.
- Diverse Market Exposure: Crypto, Forex, Stocks etc.
Performance Fees
Your traders may manage client funds or trade with the firm’s capital. Your firm earns performance fees from these activities.
- Profit Percentage: Get a share of the trading profits.
- High-Water Mark Principle: Fees are collected only on net profitable performance.
Management Fees
Along with performance fees, your firm probably charges a management fee for the assets it trades.
- Fixed Percentage: This is usually a percentage of the assets under management (AUM).
- Regular Income: Provides a steady income stream regardless of trading performance.
Business Model
In the world of proprietary trading firms, their success is based on three main pillars: sourcing skilled traders, tight risk management and developmental resources. Each is important to profitability.
Trader Recruitment Process
Your entry to a prop firm starts with a rigorous evaluation process. It may involve trading challenges or simulation tests where you are tested on your strategy, market analysis and reaction to real world scenarios.
If you pass the firm’s criteria, you’ll get access to the firm’s capital to trade and your success will be aligned with theirs.
Risk Management Strategies
Once in, your trades are managed through tight risk management protocols. Firms have position limits and require stop loss orders to protect their capital.
These are key to minimizing losses and are part of a prop firm’s risk management strategy.
Training and Support Systems
Your growth is supported by the firm’s training and support systems. These include educational resources, mentorship programs and advanced trading software.
This infrastructure helps to improve your trading, which in turn affects the firm’s profitability.
Industry Dynamics
As you look into the revenue streams of proprietary trading firms, you need to know what they do. Your understanding of industry dynamics like market making, arbitrage and scalping is important since these are how prop firms make money.
Market Making
Market Making can also be used by a prop firm to make money. You’ll find that prop firms act as market makers, providing liquidity by buying and selling securities at all times.
By quoting bid and ask prices, your firm can make money from the spread, the difference between the buying and selling prices.
This spread may be small on a per trade basis but can add up to big money over many trades.
Arbitrage
Arbitrage is a low risk way for prop firms to profit from price discrepancies across different markets or instruments.
Your firm may use algorithms to find these opportunities and trade simultaneously to capture risk free profits before the gap closes.
Scalping Strategies
With scalping, your firm is looking to make money from small price gaps caused by order flow or market inefficiencies.
These strategies require fast in and out of markets, often in minutes or even seconds.
Your traders will be trading large volumes to amplify small price movements. They will extract their edge from within the noise of the market.