The proprietary trading firm business is booming, and it may seem like more people are making money from starting prop firms than actually trading for them!
In this post, we’ll discuss the steps required to start a prop firm and the risks involved.
How to start a prop firm
Legal entity
The first and most important factor in starting proprietary trading firms is the legalities. You will have to research this depending on which country you live in.
Since there is a financial aspect involved, some countries have tighter laws regarding how companies can operate.
We’re not lawyers, and we’re not in a position to give any advice regarding where and how to incorporate a prop trading firm.
The best thing you can do is talk to a lawyer.
The Prop Trading was an Australian prop firm that ran into issues with the Australian government agency that oversees financial markets and they had to shut down overnight.
In short, getting the legalities sorted out is critical before starting a prop trading firm.
A tech stack
The next thing you need to start a prop firm is a tech stack to get customers, generate demo accounts, track rules, and track progress in live accounts.
You can either use white label technology or develop your own tech stack.
A tech stack will require:
- A front end website to attract customers and process orders
- A trading dashboard to enable customers to monitor their account progress
- A back-end software that connects to your broker to generate new accounts, track accounts, and close accounts that breach rules
- A trading software that copies the trades of successful traders onto your master account(if applicable)
Liquidity providers
You’ll also need a liquidity provider that connects you to the Forex market and lets your customers place and close trades.
For this, you’ll need to shop around for brokers who will let you use their platform. Many new prop firms use EightCap as their partner, and as of this writing, EightCap seems to be the most willing broker to work with upcoming prop firms.
Essentially, EightCap will provide the accounts, the liquidity, and eventually, the live capital that will be traded.
Deciding on rules and profit splits
Now that you have the basics of your prop firm set up, it’s time to decide on rules that prospective prop traders will need to follow in order to get access to trading capital.
There are a few models that most prop trading firms today use:
- Two phase evaluation period: In this method, a prop trader needs to make 8-10% in 30 days to pass the first phase, and then 5% in 60 days to pass the second phase
- One phase evaluation period: In this method, a prop trader needs to make 8-10% while adhering to stricter drawdown rules.
- Direct funding: Some prop firms even offer direct funding where you get access to live capital up front by paying a significantly larger fee
You also need to figure out your drawdown rules.
There are a few different drawdown models that most prop firms use:
- Fixed daily and max drawdown: This is the same model FTMO and MyForexFunds use. Here, prospective traders must not draw down their accounts greater than a fixed percentage every day(5, for example). Additionally, the maximum drawdown on their account can’t exceed a certain percentage(10 to 12, depending on the company)
- Fixed daily and trailing max drawdown: Some companies enforce a trailing drawdown. Here, your maximum drawdown increases as you generate profit on the account. For example, let’s say a firm has a 6% trailing drawdown. You start trading a $100,000 account. On day 1, your max stop out will be $94,000. Now if you profit $2,000 and your balance is $102,000, your stop out level will move up to $96,000.
Companies tend to use trailing drawdowns when they provide access to live capital. The trailing drawdown minimizes losses for the liquidity provider, and incentives the trader to manage risk better.
Providing live accounts vs demo accounts
When starting a prop firm, one of the most important decisions you’ll have to take is how you’ll use your own capital.
There are two approaches you can take.
First, you can provide your customers with real accounts once they pass the challenge, then actually split the difference between yourself and the customer. This is the least risky approach, since you’ll only have to pay for real profits generated.
The second approach is to provide your customers with demo accounts once they pass the challenge and copy the trades of successful traders onto your live capital, then use that to pay your traders.
This is a riskier approach.
You need to keep increasing your capital for every live account. If you don’t, then you’ll need to rely on failed challenge fees to pay out your traders!
According to My Forex Funds’ statistics, the math checks out, and you could get away with only paying successful traders out of your challenge fees, but it’s risky, since one big payout could wipe out your revenue and then some.
Getting customers and reviews
The last step in succeeding as a prop firm is to acquire customers to take your trading challenge.
You’ll have to tap into Forex trading communities and pitch your prop firm to potential traders.
Also, it’s really critical that your first customers leave good reviews for you on TrustPilot. TrustPilot is the gold standard for measuring the reliability of prop firms.
Of course, you’ll need to be able to pay your customers in a timely manner too, as that’s the only way you’ll get good reviews!
Why start your own prop firm?
On paper, prop firms are in a position to utilize a bucket of the best trading strategies and copy those trades to their own capital.
There’s comparatively little risk to the firm themselves at the onset, since a good chunk of potential clients may fail the challenge, resulting in revenue for the firm.
Experienced traders will pass, and copying their trades to your capital will mean you get to share their revenue.
Conclusion
Starting a prop firm can be a very lucrative business opportunity. Once you have a good number of profitable traders on your team, you can generate significant revenue.
However, developing the trust and relationships that are required before you get to this point is the real challenge!