Everything you need to know about prop firms and risk management (2024)

Prop firms, a new concept that is becoming increasingly popular in the trading industry. There are people who swear by them and people who want nothing to do with them. I myself believe that you should definitely take advantage of prop firms as long as it’s possible if you are serious about trading. It’s a unique opportunity to operate with more substantial resources and truly elevate yourself to the next level.

In this guide, I will tell you everything about prop firms, what they are, how to benefit from them, and some risk management principles to effectively tackle challenges.

Prop firms, short for proprietary trading firms, are companies that provide funds to traders to work with. This was predominantly used in the professional world. Traders build a track record and aspire to take the next step, which is managing other people’s money. Because, let’s be honest, no matter how good of a trader you are, without sufficient capital at your disposal, it’s very challenging to make a living as a trader. Capital is one of the most crucial factors and it also brings peace of mind because you don’t have to rush into trading.

The barrier to entry into the prop firm world has significantly lowered due to the emergence of new players. These new companies have introduced a gamified aspect to trading. To prove your trading skills, you don’t need a track record; instead, you participate in a challenge offered by the firm you want to join to demonstrate your understanding of the game.

What does a challenge entail? You deposit a certain amount, and in return, you receive a demo account with a specific account value. In this demo account, you can showcase your skills, and as long as you meet the targets and adhere to the pre-established rules, you become a funded trader with that particular firm.

What does such a challenge look like? The most well-known challenges are the two-step challenges. These challenges consist of two phases, and while it may vary from firm to firm, the industry standard is as follows. In the first phase of the challenge, your goal is to achieve an 8% profit on your initial starting amount. During this phase, you have a maximum drawdown of 10% of the starting amount and a maximum daily loss of 5%. This means that if you start with an account of $10,000, the maximum drawdown is $9,000, and you must remain above $9,500 initially since you have a maximum daily loss of 5%.

The second phase of the challenge is essentially the same. You still have to follow the same daily and maximum drawdown rules. However, what we often see is a decrease in the profit target. In the second phase of the challenge, you usually need to make a 5% profit.

Once you have successfully completed both phases, you can call yourself a funded trader.

A schematic representation of the challenge structure:

When you have successfully completed the challenges, you receive the funds to trade with. It’s important to note that you will operate in a demo environment. No prop firm that offers a challenge will provide you with live funds to trade.

If you manage to generate profits on your funded account, you can request a profit split after a certain number of days, and you (usually) get to keep 80% of the profits.

For me personally, the most important benefit is acquiring more capital. As mentioned earlier, it’s quite challenging to work with limited capital while maintaining a good risk profile. More capital brings peace of mind, and even small gains can yield significant results.

Secondly, during trading, you do not risk your own capital. You are trading with the prop firm’s account. So, while trading, you don’t risk your own money to potentially make a profit. If you lose the account due to violating any rules, you lose the account, but there are no additional consequences like losing extra money.

You build a track record. When you have a certain skill, in this case, trading, you are not solely dependent on prop firms. If you consistently demonstrate profitability through payouts, a whole new world opens up for you, including private investors and fund management, if you’re interested.

When the challenge is successfully completed and you reach your first payout, you receive a refund of the initial challenge deposit. Becoming a funded trader does not have to cost you any money.

Lastly, you can scale up to a very large capital, allowing you to make substantial profits with very low risk per trade.

Completing a challenge account is difficult, and it can be mentally challenging because you must meet specific criteria before you can progress. This pressure can lead to underperformance and failure to complete challenges. Statistics show that only a small percentage of participants become funded, demonstrating how challenging it can be.

You are dependent on a company. These are businesses you are dealing with, and there are inherent risks. Will they pay out? You are always reliant on a company, so it’s essential not to rely solely on your prop capital and to seek additional income sources alongside prop trading.

You are 10% away from blowing up an account. With good risk management, it’s difficult to lose an account, but it’s crucial to realize that you can lose the account.

I would suggest doing so when you have a system that is genuinely profitable. It’s essential that you have documented your system and that the statistics indicate that you can successfully complete a challenge.

When you start, begin with a small account and gradually scale up. There’s no point in diving headfirst into it; this is likely to be mentally overwhelming, and there’s a higher chance of failure.

Risk management

After going through the whole story you’ve decided to take on a challenge, you have a system you trust and want to proceed with a challenge.

I have certain risk profiles that you can use during the challenges, which I have depicted in the following diagrams:

Phase 1:

Phase 2:

Funded:

Once you are funded, ensure you achieve your first payout. Make a small profit and leave it until you can be paid, which ensures you get your initial deposit back, making your account essentially risk-free.

After your first payout, risk very little, I would say 0.25% to 0.5% maximum. Build a buffer before taking on more risk. Have you achieved a 3% to 6% profit? Congratulations, leave your profits in until you receive a payout and allocate a portion of your winnings to scale up to new accounts.

Written by: Daan Foppen