Prop Firms

Propfirms are companies offering traders an opportunity to use their skills to trade for them. They claim to offer real capital for you to trade, after passing what they call an evaluation test.

Your relationship with a propfirm goes through 3 phases in general:

The first phase is called the evaluation test phase

You start your relationship with a propfirm by paying them to let you pass an evaluation test. During this evaluation test, you are given virtual capital to trade with, a profit target that you should reach in a specific period of time, and very strict maximum drawdown rules.

At the end of this period of time, if you reached the profit goal without breaking any rule, then you successfully passed your evaluation test, and you can move on to the next phase.

On the other side, if you didn't reach your profit goal, or you did break the rules, then you failed your test, and you should pay again for another evaluation test and start over the first phase.

The second phase is where you trade to generate real profit

After you successfully passed your evaluation test, the propfirm will give you a digital certificate and make you sign a contract.

The propfirm will claim to allocate real capital for you to trade. This is not entirely true. What really happens is that the propfirm will use the money they collect from other customers who fail the evaluation tests, to pay you if you generate profit during this phase.

Propfirms make big profits from their customers who fail their evaluation tests — this profit is largely sufficient to pay anyone who succeeds their evaluation test and later requests a payout. Generally speaking, only 10% of customers pass evaluation tests.

The third phase is when you raise a flag on the propfirm's internal systems

Propfirms monitor all their customers' activity. If you generate profit in a consistent manner, the propfirm will detect you and will flag your profile. This is not a bad thing.

Each propfirm has its own way to manage their operational risk. If you generate a lot of profit, then the propfirm will need to pay you from the money they collect from their customers, so you are basically eating into their profit. The solution for this issue is that propfirms will copy your trades while adding an additional layer of risk management, so that they reproduce your trades on their side. This way, they pay you from the profit they generate by copying your trades. Of course, this won't happen the first month you generate profit — you need to consistently generate profit over a long period of time for this to happen.

Rithmic is the company that provides the price and trade connection you use from your NinjaTrader software.

Suppose you started your own propfirm company — the first thing you'd need to do is sign a contract with Rithmic to provide your users with NinjaTrader connections. Then you'd link your backend service with Rithmic's service, and each time you get a new user, Rithmic will allocate them a new connection. Rithmic will also provide all transaction and order history for each user.

Yes. Even though only 10% of propfirm users pass their evaluation tests, you can be one of those 10%.

With propfirms, even though they claim to allocate real capital for you to trade, you are never trading real money. You are always trading a virtual account with virtual money on it. But the profit you generate on this virtual account will be paid to you in real money.

Propfirms will decide to copy the trades of successful traders internally as a way to generate more income.

So as you can see, propfirms don't have a legal issue with letting retail traders manage the money of other people. Legally speaking, they are paying you for a service that you provide for them — the service is your trading signals.

To answer this question, one should define their objective first. For myself, my objective is to have a long-term consistent income from payouts.

This target objective makes choosing a Propfirm come down to the following criteria:

Criteria related to monthly payments

This is one of the most important criteria when first looking into a propfirm's offers. If you are aiming to create a consistent flow of income from payouts, you should maximize your gains and minimize your expenses. There are three types of propfirm programs or offers:

• Programs that require monthly payments from the start, and always.
• Programs that require one payment only at the beginning.
• Programs that require a cheap monthly payment at the beginning during the evaluation phase, then one payment when you pass evaluation.

The propfirms to avoid are of the first type. You should avoid propfirms that require you to pay a fixed monthly payment. Imagine you have the objective to use a propfirm for 12 months, and the monthly cost of that propfirm is $80. This totals to 80 × 12 = $960 per account per year. Suppose you open 10 accounts — that would cost you $9,600 per year. That's a very high amount you can avoid paying.

The other two types of programs let you pay only at the start of the program. For example, you can pay $140 once for a 50k account for as long as the account is active. As you can see, the difference between the two expenses is very obvious.

Criteria related to trailing stoploss

Trailing stop loss is a mechanism used by propfirms to liquidate your account if you go below a certain loss level. This loss level is calculated based on the level of profit in your account. For example, let's say the trailing stoploss is a trailing $2,000 End of Day — this means the stoploss level (notice that this stoploss is not a price, but a PnL value) is recalculated at each day (after the trading session closes) and is equal to your current PnL minus $2,000. This stoploss level can be trailing, meaning it will go up following your increasing PnL. When you start the account at $50k, it is located at $48k, and if your PnL reaches $55k for example, it will be recalculated to $55k − $2k = $53k. Notice that the stoploss level only goes up — meaning if, after that, your PnL suffers from multiple losing days and hits $53k (down from $55k), your account will be liquidated.

Now that you have an idea about trailing stoploss, you should know there are 3 types of stoploss that propfirms propose:

Realtime Trailing Stoploss

This one you should run from and never use. You can never succeed with this realtime stoploss mechanism, because it is designed to increase the stoploss level at the highest PnL level you reach in realtime during the day while a trade is still open. This trailing stoploss is designed to rip you off. Stay away from it.

End of Day (EOD) Trailing Stoploss

This is an acceptable trailing stoploss mode. I say acceptable because it is not the ideal one, but it is the most common mechanism used by propfirms, so we can use it.

If you intend to target long-term consistent income, you need to withdraw your payouts frequently under this trailing stoploss mode. Let me give you an example: suppose you want to accumulate profit on a propfirm account for 12 months, then withdraw your gains, and suppose you reached $20k profit on a $50k account after 10 months of trading. Your trailing stoploss will be at $20k − $2k = $18k.

Suppose now that the strategy has a very bad week and loses for 5 consecutive days, and you hit the stoploss level of $18k. Now you've lost all your gains.

Now, if you had withdrawn your gains periodically at each $2k profit step, you would have lost only $2k, and it wouldn't matter if you lost your account, because you would have already withdrawn the money from it.

Static Stoploss

The static stoploss mode is very rare to find among propfirm offers. The static stoploss will be fixed at an initial value and will not follow your profit.

This mode is ideal for long-term payouts, because you can accumulate profit without fear of blowing the account.

As you will see later, some propfirms that offer this mode will add other constraints to their offer to minimize your profits.

Criteria related to limited contract size

One of the hidden constraints propfirms add to their offers is limiting your maximum contract size per trade. By doing this, they limit your capacity to make large profits in a short period of time.

For example, they will offer a 1-day validation period, but with only 3 maximum contracts on the Micros. If you read between the lines of this constraint, it is a way for the propfirm to guarantee that you spend more time reaching your validation or payout target, and thus pay them more before they give you a payout.

Now that you are knowledgeable about the different aspects of evaluating a propfirm offer and reading between the lines of their programs, let's dive into real examples.

For the sake of simplicity, I will only focus on 50k account offers, and I will challenge the propfirms against the criteria I have defined above.