I get asked a lot about futures prop shops so in this article I am going to offer some thoughts.
What is a Prop Shop?
A prop shop is a firm that uses its own capital to provide funding for traders. They also typically provide education and training to those traders (more on that soon) but there are some online (virtual) versions of prop shops who don’t teach but rather take on traders who can show profitability.
Prop shops started to appear after pit trading ceased initially as a place for floor traders to trade from. But quite quickly, the owners saw the potential to bring many more traders in by providing training and funding.
The first prop shops that I encountered in London had a model along the following lines. The new interns were selected following interviews. They did not pay for their education, instead they were trained by the firm and would only be taken on and backed if they showed that they could trade profitably. When they went live, new traders would only trade very small size. Each trader paid a desk fee per month and commissions per trade.
The education was usually conducted by an experienced floor trader who shared their knowledge and skills.
The firm wanted their traders to trade different markets to spread risk and many were taught futures spread trading techniques. In fact in some firms, spread trading (along the bond curve or short end of the curve) was the most widely used strategy. It ticks the boxes of being low risk, market making style and high volume.
Risk managers closely watched the firm’s risk to ensure not too much exposure to any particular direction risk.
These prop shops actually delivered a number of successful and skilled traders.
The early prop shops had two main sources of income one being the profitability of the trading desk (they were trying to be profitable) and the second being profit from the commissions they were charging to their traders.
As the early firms got bigger, some had dozens of traders trading high frequency techniques which made them some of the highest volume futures trading accounts in the world.
Realising the potential power associated with trading such high volumes, the prop firms were able to negotiate big discounts and rebates from futures exchanges. This increased the profitability from commissions; commissions charged to traders vs commissions paid to exchange/clearer (the bigger players were full clearing members of the exchanges while others were not).
We can call this this fee arbitrage.
As the profits from fee arbitrage increased, the prop firms realised that they no longer needed the trading desks to be profitable. Flat P&L was more than acceptable and could be achieved through risk management.
This coincided with the rise of automated HFTs and prop firms were concerned at this time that trading profits would diminish anyway.
The Game Changed
The game for prop firms was now primarily about volumes. Interestingly this is a similar model to many HFTs (see my previous article here).
At this time some firms stopped or reduced the amount of training provided to new traders. Training was now quite basic, often just covering how to use a DOM and the basics of trading. New traders essentially had to figure out how to be profitable by themselves. This was because, trading profitability was no longer the main game.
Some firms opened new offices around the world including places such as India where they would recruit dozens of new traders at a time. Some even charged new recruits for the opportunity to be trained and work at the firm.
Only traders who showed promise were kept while the majority were let go. I have spoken to people who were part of these cohorts and they told me how the training was poor and the success rate of new traders was extremely low. I was told of cohorts where none of the traders lasted more than a few months (cohorts could be anywhere between 10 and 30). The few who became good traders did so despite the training they received not because of it.
The Numbers Game
So in every sense, these prop firms were operating a numbers game. Profits primarily came from fee arbitrage; P&L risk was still low by having so many traders trading different markets with low risk thresholds and the sheer volume of new traders passing through each year meant there would always be some winners. New traders are given very small limits and even then the losing traders are cut quickly. So over time the firm is only left with the better ones.
Survivorship bias means that you only hear about the winners and your view of how successful prop firm traders are will be skewed by that.
But even among the traders who remain, while every day some of the traders will win and some will lose, the prop firm doesn’t care who these are or whether today’s profitable trader is also profitable tomorrow.
What we need to understand as individual traders is that we need to be profitable week after week, month after month. So our goals do not align with these firm’s.
The firm doesn’t care if we as an individual are profitable enough to earn a good living. As long as the desk is roughly flat P&L every day, the firm wins.
To retail traders, prop shops can appear to be a way into the professional trading industry. These firms earned a good reputation in the early days of electronic trading when they did develop some good traders. Somehow they have managed to keep that reputation despite the fact that their business model has changed. Nowadays the training they provide both internally (to new recruits) and externally (with paid courses) is generally nowhere near professional standard.
Frankly there are some firms and well known traders within them whose trading education is bordering on the junk and bears no resemblance to the quality of the pioneers of this sector.
During the transition to the numbers game/fee arbitrage model, old school traders were let go from their teaching roles and their skills lost. The education that these traders provided had produced some excellent traders but the firms had found an easier and cheaper business model. You will now find very few if any spread traders at these firms.
Some firms have moved away from futures to cryptocurrencies which I find intriguing. I’d suggest that having lost the knowledge base to remain competitive in the futures markets they had to seek out new markets. But the crypto markets come with various forms of additional risk.
To the outside world some of these firms are now promoting training education which is essentially retail style. They don’t have the knowledge to teach spread trading or other professional style methods so they teach levels, indicators or macro style methods. All of which carry more risk and lower success rates. The education they offer is a giveaway that the firms are no longer what they used to be.
Today, for most prop firms, fee arbitrage is likely to be the main game and source of profit. If you are enticed by these firms then you should bear this in mind.