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Proprietary trading meaning and definition for dummies

Proprietary trading meaning and definition for dummies

Written by

Justin Cox

Written on

Mar, 2024

Updated on

Mar, 2024

Table of content

Proprietary trading, more commonly known as prop trading, is a form of investing in the financial markets where companies use their own capital to speculate on asset prices for the purpose of making money.

Some prop firms hire professional traders and beginners, and teach them their own strategies to speculate on financial markets. Profits are split with ratios that are already agreed upon. In addition to access to high quality educational material, many prop firms provide traders with office space, and essential tools and techniques for effective market analysis.

Some prop firms, especially online proprietary trading companies, use completely different methodology. Most online prop firms offer funded accounts to traders that can successfully pass their trading challenges. Trading challenges typically have a couple of stages. Traders are given time frames, profit targets, and daily and trailing loss limits to lower risks.

Traders that wish to get funded accounts typically have to pay challenge participation fees, and the amounts are different for each funding plan and from prop firm to prop firm. Once the evaluation period is over, traders get funded accounts. However, the next goal for traders is to keep trading in line with predetermined trading conditions, to keep their accounts, which can be stressful for many traders.

Prop trading terminology

Prop trading firms use specific terminology to describe their trading plans and challenge conditions. Let’s take a look at some of the key ones:

  • Daily Loss Limit: The maximum amount of money a prop trader is allowed to lose in a single trading day. The daily loss limits play an important role in managing risks from the firm’s perspective. In addition, daily loss limits are great for emotional management, as they make revenge trading impossible and traders become more accountable. The typical daily loss limit is 5% of an entire account balance, but can vary from firm to firm.
  • Profit Target: traders are given profit targets to meet in order to get funded, and keep their trading accounts. Typically, profit target is at 8%, but can be different spending on a prop firm.
  • Trailing Drawdown: trailing drawdowns are peak-to-trough declines in trading balance.
  • Risk management: set of strategies, limitations, and techniques set by prop firms and individual traders to control and mitigate potential losses.
  • Position sizing: prop traders need to be super careful when selecting their position size. Position size refers to determining the appropriate amount of capital to allocate to a specific trade.

Prop trading characteristics

The main benefits of prop trading from the traders’ perspective are: increased accountability, access to large trading capital, high profit potential, performance based compensation system, and support from prop firms. However, there are many downsides to consider. Some traders find it mentally difficult to manage large sums of money, even if the trading strategies are the same. For example, when you only have 200 USD on your trading balance and lose 10%, you will feel bad, but that’s nothing compared to losing 10% on a 200,000 USD account. Liquidity problem is generally non-existent for prop traders when they speculate on major currency prices, however, if traders decide to trade less liquid instruments, such as exotics, minors, or certain share CFDs, lack of liquidity can become an issue.

In addition, let’s not forget that prop traders are much more restricted than retail traders. Availability of high leverage is also very limited by most prop firms. The maximum available leverage they typically offer is around 50:1.

Overall, prop trading is a great way for traders with low budgets to access capital needed to trade professionally, however, there are various things to consider, such as challenge fees, trading conditions, challenge terms, and profit-sharing.

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