Introductory Training Course

Fl!P Your Thinking

module five

More on Prop Trading

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Introduction

The prop trading industry experienced explosive growth during and after the Covid-19 pandemic. A fist full firms, mostly American, offering futures products, go back to the period just after the GFC. FTMO, a flag bearer in the spot forex category has been established by two Turkish students in 2014. Although they were successful traders they were frustrated with the fact that due to small accounts, their profits weren't enough to realize their goal to be full time traders for a living. Based on the assumption that their experience wasn't unique they came up with the current business model in the forex and CFD prop trading industry.

The business model

The business model is straight forward. Clients can pay for a trading evaluation on a demo account in which they are supposed to prove their trading prowess. If they pass the evaluation they receive a "funded account," which means little more than a similar demo account but profits are paid in real money. In many, if not most, cases profits are funded by the evaluation fees of unsuccessful candidates. Until as recent as 2023 almost all firms gave traders a short period of time, like a month, to make 10% profit. Suffice to say, by far most failed their challenges, and had to go back to the beginning to start all over again.

The business model is very attractive for the owners. Because the number of 'funded' traders is minimal,

there is plenty of money from challenge fees to pay the profitable funded traders.

Gambling behaviour

The originally short period (2 weeks to a month) allowed to achieve relatively high profits (10% + 5%) likely contributed to gambling behavior among many traders. This encouraged them to use highly leveraged trades to pass the challenge quickly and start trading real money, often with similarly high leverage. This unintended consequence of the business model could negatively impact profitability, leading firms to implement rules to limit gambling behavior.

Removal of time limits

I initially dismissed prop trading as a 'scam' due to the unrealistic profit-to-time-limit ratio. However, I realized it could provide a solution to one of the most pressing problems: having trading accounts that are too small to justify the effort required over a longer period. A few firms began, in rapid succession, to extend the time allowed to pass the challenge/evaluation phase to three or even six months. Then, around mid-2023, the proverbial dam broke, and the removal of time limits became the norm. Rules aimed at curbing gamblers and traders using excessively high leverage for intra-day trades, doesn't present serious limitations for low and very low-leveraged trading. Game on!

Regulatory developments

About 33% of the industry falls under U.S. jurisdiction and 15% under U.K. jurisdiction. The CFTC (U.S.) and FCA (U.K.) are very strict and active regulators, focused on protecting retail participants in the financial services industry. Prop firms operate in a gray area because of the simulated real market conditions (demo trading). They provide a service rather than traditional investments or investment advice, placing them outside typical financial services regulation.

However, alongside the positive developments of removing time limits in mid-2023, a regulatory shock hit the industry. On September 1, 2023, the U.S. regulator, the CFTC, filed a suit against My Forex Funds (MFF), probably the largest and most popular prop firm in the U.S. at the time. The primary allegation was that while MFF claimed that clients in the funded phase were trading directly with third-party liquidity providers, MFF was, in fact, acting as the counter party for most trades.

As a direct result of this action, other firms in the U.S. and globally quickly adjusted their marketing practices and legal documentation to reflect the truth: trading in both the 'evaluation' and 'funded' phases is done using virtual accounts and simulated money, only mimicking real market conditions. Until then, the public generally, including yours truly believed that profits were funded via real market liquidity providers. The MFF case is ongoing and will likely provide further clarity on how the CFTC views regulation in this space.

Stability and counter party risk concerns

It is clear and obvious that the prop trading industry offers a product the public wants. It is also clear that the established firms in the industry have turned the corner and are very profitable. The latter is very important. Because of their profitability, these established firms have a huge incentive to improve their product, anticipate, and comply with any regulation, as it will most likely work in their favor.


In early 2024, another shock hit the industry. It was a bit difficult to determine to what extent it was driven by regulation (again in the USA) and to what extent by business considerations, such as anticipating possible regulatory enforcement action.


The main trading platform provider in the industry, MetaQuotes, owner of the MetaTrader platform, started revoking the licenses of some customers, including forex brokers, operating stealthily in the prop industry by providing the use of the MetaTrader platform under their licenses to prop firms. Some of them did so outside the terms of the agreement and MetaQuotes threatened to cancel their agreements. They had to stop providing services to those prop firms.


This had a negative impact on the prop firms. Given their limited technological infrastructure, they were left stranded. Some of them couldn't restructure and had to close their doors.


Additionally, MetaQuotes forced those licensees who didn't skirt the rules of their agreement to stop providing services to U.S. residents. The reason being that after the action against MFF, MetaQuotes was concerned they would come under fire because their licensees offered CFD trading, which is illegal in the U.S.


Some of the more established and better-capitalized prop firms were direct licensees of MetaQuotes or had legitimate white-label agreements with MetaQuotes licensees. Most of these firms stopped offering services to U.S. residents to keep their MetaQuotes licenses. That this wasn't a direct regulatory enforcement became clear when the affected prop firms started offering other trading platforms to accommodate U.S. clients.


The positive of these developments was the shakeup and cleansing of the industry. Many firms had to reorganize or close. The FTMO founders reckon only two or three firms will eventually dominate the industry. It is thus important to be careful in deciding who to deal with. The consolidation and shakeup in the industry will continue, especially if it becomes clear how global regulators will approach regulation.

The Trading Rules

Initially, the industry solely focused on intraday trading. Most firms didn't allow positions to be kept overnight or over weekends. Trading in volatile markets during major economic data releases and central bank announcements was also prohibited, and in some cases, it still is.

These limitations were problematic from a "swing trading" perspective. With the lifting of time restrictions, most firms also dropped these rules for what they call "swing trading accounts." This change removed all significant obstacles to achieving the ultimate goal of trading for real money profits, particularly for anyone using a low-leverage, low-risk approach.

"Unless clearly stated otherwise," the same rules apply in both the evaluation and funded stages.

This is an important point. Short-term thinking may lead one to see some parameters as more favorable. However, considering the long term first and foremost may change your perspective. For example, the draw down rules are tighter, around 3% and 6% for One-Step challenges. These limits carry over into the funded phase and could limit sustained success. Below, we discuss some of the more important rules.

Draw down Rules


Overall draw down

The total percentage negative return at which the evaluation/challenge fails. For two-phase evaluations, it is industry-wide -10% of the initial capital value. For one-step challenges, it is less, more like -6%.


Another factor to consider is whether this draw down is static or trailing. The ideal scenario is a static draw down. The best way to explain this is with numbers:


Say you trade a $100,000 account. The -10% overall draw down limit is $90,000.


If it is static, as you make gains—say up to $105,000—the draw down limit remains at $90,000.

If it is trailing, as you make gains—say up to $108,000—the draw down limit is at $98,000 but will stop trailing at $100,000. This has some technical implications for profit share ("payouts"), depending on how a firm applies the trailing limit.

If static, the firm may find ways to make growing the account unattractive, by paying out profits very regularly (weekly or bi-weekly), thereby resetting the account to $100,000 every time.


Daily draw down


This is usually set at -4% or -5%. For both FundedNext and FTMO, it is -5%. This rule is clearly designed to discourage overly leveraged trading and generally knocks out many more traders than the overall draw down.


The rule can be applied as balance-based or equity-based. The account balance includes capital plus profits/losses from closed positions. The account equity includes capital plus closed trades plus the open trade value in real-time.

With the preferable balance-based approach, the low point of the day at the start of the day remains fixed, but profitable closed positions during the day increase the leeway to more than 5%.


In the equity-based approach, the lower limit trails the equity at the 5% level in real-time. In other words, even closing a position at a profit doesn’t give you any more leeway, unlike in the balance-based approach. There are also other factors to consider, such as what constitutes a trading day, server time, your local time, or U.S. Eastern time.

Other Rules

Consistency rules

To counteract "gamblers," there are rules specifically limiting outlier (big) profitable trades. One way is through a hard profit cap per trade. Additionally, per-day profit caps may apply. Another method to enforce consistency is to limit the contribution of any one day or trade to a percentage of the total return during the challenge/evaluation phases. These rules generally will not be a concern for low-leverage traders.

Misuse

Traders are not allowed to use trade signals or copy trades from third parties.

Some firms allow you to copy trades out of your account but not to receive copied trades.

Copying trades between your own accounts at the same broker is generally accepted.

Hedging positions (same pair in separate accounts at the same broker) is not allowed.

Some firms also take issue with hedging with third parties or with your own accounts at other prop firms. However, this would be difficult to enforce.

To ensure that only the account holder trades on the account, there may be rules about VPSs and identifiers such as static IP addresses or unique identifiers of mobile devices.

There are many other, less critical rules that may become relevant to you at some point. It is best to study the relevant websites, ask questions via online help, and so on.

'Payout' procedure

All trades must be closed to activate a payout. They will close your positions if you haven't done so yourself. This can be a downside due to the enforced payout frequency for swing traders. However, nothing stops you from reopening your positions as soon as possible.

Up-scaling an account

Most prop firms have a process to automatically increase account capital if you trade profitably over a period of time, such as 3 to 4 months. For example, if you reach a 10% profit over a rolling three-month period, your account capital is increased by 25%. The draw down levels are adjusted for the new starting capital amount.

(In most cases, this should not prevent traders from increasing their trading capital through additional challenges. If successful, every 'funded account' can also grow organically).

How to slash your risk of failure due to draw downs

Risk of failure

When strict time limits were applied, the failure rates during the evaluation phases were horrendous. Undoubtedly, the removal of time limits had a very positive effect on pass rates. According to information provided by some firms, the main reason for failure is daily draw downs, followed by overall draw downs.

High failure rates can mainly be attributed to excessive leverage.

Since the start of my involvement in retail forex trading, I have advocated for a drastic reduction of leverage. Nevertheless, the aggregate leverage from multiple simultaneous trades can still bring the draw down limits uncomfortably close at times.

Huge setback

Due to the potentially life-changing nature of the prop trading opportunity—an opportunity not available to most in the classic own-account trading model—failure at an early hurdle should not be an option.

There is nothing more damaging to your dreams than doubting the approach you initially started with, likely full of hope and confidence in your "system," only to see it crash and burn in short order. To add insult to injury, this failure occurred during a period with no time constraints.

According to a recent small survey at one prop firm published in Finance Magnates, the typical trader who reached a funded account paid more than $4,000 in evaluation fees. This underscores my contention that losing traders often start on the wrong foot. You should have a dogged determination not to blow up your first account.

A practical approach to risk reduction

Unlike in the classic retail forex industry, where demo accounts are plentiful, prop firms mostly don’t offer demo accounts. Those that do typically impose 'old' time constraints. Unless you enter prop trading with a working trading strategy that has withstood the test of time in YOUR hands, you may face significant challenges. While there are no time limits, they usually require you to start within a specific time frame after receiving your account credentials.


Even if you have a trading strategy that works for you, something else will pose a challenge: the sheer size of the potential profits can drive and motivate you to rush the challenge, despite the risk of failure before any payout. It may be prudent to scale into your desired account size. However, starting a new challenge with a larger account every time is not ideal.

Secure the maximum account size you can afford

Securing the maximum account size you can afford will help you address the problems mentioned above. It will also incentivize you to commit, focus, and tackle various obstacles between you and achieving payouts with confidence and sustainability. While you may offer up a bit of extra time, this increases the odds of initial success (passing your evaluation) and sustainable success over time.

'Create' a few 'virtual' accounts

Since you have secured a large account nothing (nobody) forces you to trade at your 'maximum.' You have already leveraged your fee about 200X. In stead of just start with intermittent smaller position sizes, but with a mindset that you are wasting time because you have this large account, actually start with a small virtual account which you can then step up in value.


Three main benefits accrue:


Draw down Limits: The real account's draw down limits won’t come into play as you chip away at the profit target. (You trade a virtual account of, say, $25,000 to start with on a $100,000 evaluation account, but the draw down limits are those of the $100,000 account.)


Strategy Development: Without the pressure of trading the "real deal" (this is not a demo of a demo), you can work on your strategy (if needed). If you try a new strategy, you can quickly apply it at very low risk while still aiming for the profit target.


Psychological Preparation: You can address the most important psychological aspects of trading before risking your full amount, all while working toward the actual profit target.

Example

In the example below, the main account is $100,000. The profit Target is 8% - $8,000 (FundedNext Stellar Eval).

Let’s assume an inexperienced trader is using a new trading strategy and starts with a $25,000 virtual account. He will adapt trade sizes as if he trades only $25,000 of the $100,000.

Because the 10% overall draw down is $10,000, on this account it is 40%.

Because the 5% daily draw down is $5,000, on this account it is 20%).


He has no reason to stress about that (if he follows his low leverage trading rules) and can focus on adhering to the evaluation rules, growing his confidence, gaining experience, and building the right mindset to overcome psychological challenges as he increases his virtual account sizes to $50,000, $75,000 and eventually $100,000.


The column on the right (top row) represents the profit target of the $100,000 namely $8,000 (8.00%).

For each of the three virtual accounts, the profit target is 3% (2nd column).

The $-values of his virtual accounts are in the third column.

The column on the right contains the cumulative gains on this virtual accounts. All-in-all they add up to $4,500.

As a result when I trades on the $100,000 account he only needs an extra 3.50% to reach the $8,000 target.

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