Christopher Lewis
Retail prop trading continues to expand and ranks among the hottest trends, but most potential retail prop traders do not understand the business model. They only look at massively funded accounts, but how do prop firms make money? I will explain the business model of retail prop firms, the difference between retail prop firms and professional prop firms, and help interested traders make an informed decision before starting a paid-for challenge with a Forex prop firm. The first step is understating how retail prop firms make money.
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Understanding the Business of Proprietary Trading Firms
There is a stark difference between the revenue models of retail prop trading firms and those of licensed, professional financial firms, hedge funds, and firms that specialize in high-frequency trading. I will focus on the business model of retail forex prop trading firms and explain their approach.
Before answering the question of how prop firms make money, retail prop traders must understand the following:
- They will never trade real money and always manage demo accounts
- Retail prop firms use copy trading software to copy trades from demo to live accounts they manage
Here is the business model of retail prop trading firms:
- Managing partners have trading capital
- Retail prop firms seek profitable retail traders that lack capital
- A paid-for challenge model serves as an initial test and a massive monthly revenue stream
- Few retail traders pass the challenge.
- Retail prop traders pay a monthly fee for access to capital
- A profit-share model provides the prop firm with ongoing capital and rewards traders with income
- Strict risk management protocols leave little room for error, and retail prop firms kick out traders as soon as they breach a tight drawdown window
How Do Prop Firms Make Money?
While most retail prop firms may claim that they earn when their prop traders earn, supported by the profit-share model, many retail prop firms earn most of their revenues from paid-for challenge fees and monthly subscriptions.
Here is an example:
- Assume prop trading firm ABC has 10,000 funded prop traders who pay $150 per month for access to capital, generating $1,500,000 in monthly revenue without placing a trade
- For each funded account, assume 100 traders fail the challenge, which costs $100, or 10,000 (funded traders) x 100 (failed traders per funded account) = 1,000,000 x $100 for a total of $100,000,000 in one-off revenue
Noteworthy:
- The more capital traders seek, the higher the one-off challenge fee and monthly subscription
- Prop firms have restrictive trading conditions and the retail trader will lose access to capital if they hit the tight daily and overall loss limits. This results in traders either blowing their account or generating relatively small profits, of which the prop trading firm takes between 10% and 50%
The Challenge Model
The challenge model presents the most substantial one-off revenue stream. Potential retail prop traders pay a fee to participate in the challenge. They must meet select criteria to pass the challenge and receive a funded account. The size of the participation fee depends on the amount of capital they seek.
The Profit Split Model
The few retail traders that pass the challenge receive a funded account with a profit-split model, where the prop firm makes between 10% and 50% of revenues. Prop traders must consider this against the monthly subscription fee to compute their break-even point.
Where Do Prop Firms Get Their Money?
Most retail prop firms get money from one-off challenge fees and monthly subscription fees paid by funded prop traders. Trading revenues, if any at all, rank third among their income streams. Managing partners usually provide the initial capital to fund operations.
Profitable Traders
Profitable traders form the backbone of professional prop trading firms. Regrettably, at retail prop firms, profitable traders fulfill a much less integral role. The best retail forex prop firms will maintain a group of profitable traders with a proven history as an income source.
Monitoring of Revenue Streams
Retail prop firms deploy sophisticated software to monitor traders, assess risks, and decide which trades to copy into their live accounts. Retail prop traders always manage demo accounts, and prop firms choose which strategies to execute.
Bottom Line
How do prop firms make money? Retail prop firms generate most of their income from one-off challenge fees and monthly subscriptions by funded traders. Trading revenues come in third, and some retail trading prop firms have no trading revenues. Retail traders should not consider prop trading, which is a challenging profession. In fact, most retail prop firms bank on traders failing their fee-based challenges or violating strict risk management rules.
FAQs
Are prop firms a pyramid?
It depends on the prop firm, but many retail prop firms operate a combination of a pyramid scheme and an internal copy trading platform. They seek profitable traders, and those skilled enough can earn significant revenues for the prop firm and themselves. Additionally, retail prop firms make an excessive amount from paid-for challenges and monthly subscriptions, which suffice to pay profitable traders and generate revenues for the prop firm without having sustainable trading profits.
What happens if you lose money in a prop firm?
Retail prop traders trade demo accounts and never lose real money. The prop firm copies trades, and accepts a certain level of risk, which is part of trading. For each funded account, there could be 100 prop traders who fail the paid-for challenge, and funded traders pay a monthly subscription fee. With tight risk management, the monthly non-trading revenue streams offset any potential losses the prop firm faces from a failed prop trader strategy, who loses access once a restrictive loss level triggers, for example, 5% of the funded account.
How do prop trading firms get their capital?
The managing partners provide the starting capital, and prop firms have an excellent monthly revenue stream to fund the few profitable prop traders. While retail prop firms offer well-funded accounts, they do not require as much capital as prop traders trade in demo accounts, which prop firms copy to their live portfolios. Given the strict risk management protocols, prop traders will trade far less than their visible portfolio.
How much money can you make with a prop firm?
The earnings potential depends entirely on traders. Retail prop firms have revenue-shares ranging from 50% to 90%, and some provide funded accounts up to $2,000,000, even more in select circ*mstances if the traders deliver consistency and above-average profits.
Where do prop firms get their funds?
The initial funding comes from the managing partners, with minor revenue streams from auxiliary services like leasing their technology or providing educational resources. One significant and guaranteed recurring monthly revenue stream comes from subscription fees for their services and one-off costs for the challenges potential prop traders must pass. Prop firms also generate income from profitable traders via the profit-share system.
Do prop firms give you real money?
Traders must understand the difference between prop trading at a financial institution and retail trading at an unregulated prop firm. Professional prop traders employed by licensed financial firms who trade on the trading floor of their company trade real money. Traders who seek capital from prop firms while trading from the comfort of their homes will almost always trade a demo account, which the prop firm monitors and copies into real money accounts they control. It ensures complete risk management and legal compliance.
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About Christopher Lewis
Christopher Lewis has been trading Forex and has over 20 years experience in financial markets. Chris has been a regular contributor to Daily Forex since the early days of the site. He writes about Forex for several online publications, including FX Empire, Investing.com, and his own site, aptly named The Trader Guy. Chris favours technical analysis methods to identify his trades and likes to trade equity indices and commodities as well as Forex. He favours a longer-term trading style, and his trades often last for days or weeks.
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