What it means
Most financial firms earn fees from clients, for example by managing money or arranging trades. A prop shop is different because its income comes from the trading itself.
It buys and sells shares, futures, options, currencies or other instruments, aiming to profit from price differences, speed or skilled judgement. Inside a typical prop shop, each trader is given a limit for how much capital they can use and how much they can lose in a day or a month.
If a trader hits the loss limit, trading is stopped until the risk team has reviewed what happened. This discipline is the heart of the business, because a single unchecked trader can lose more than the firm can afford.
Traders are paid mainly through a profit share. A common arrangement is that the trader keeps a percentage of net profit, such as 50% to 90%, and the firm keeps the rest as payment for supplying capital, technology and risk systems.
Some firms also charge desk fees or require the trader to put up a small deposit. Prop shops come in several types.
Some are quantitative firms that use fast computers and algorithms, some are discretionary firms where people make trading decisions by hand, and some are online funded-trader companies that sell evaluation challenges to the public. The business models of these groups are quite different, and a person considering joining one should read the terms carefully.
Regulation varies by country, and in some places banks are restricted from running their own proprietary trading desks. This is one reason why independent prop shops have grown in importance in some markets, and why anyone who deals with one should confirm how it is regulated.
In practice
Real-world examples.
Example
A former bank trader joins a prop shop with a $500,000 trading limit and a 75% profit split. After a year she has made $240,000 of net profit, so she receives $180,000 and the firm keeps $60,000.
Example
A technology-focused prop shop builds an automated strategy that earns a tiny profit on millions of trades. Its edge comes from speed, so it spends heavily on servers and data feeds that smaller traders cannot afford.
Example
A university graduate pays $300 to take an online evaluation offered by a funded-trader firm. If he reaches the profit target without breaking the loss limit, he receives access to a $50,000 account, and the firm shares profits with him.
Formula
Calculation
The basic payout to a trader under a profit split is:
Trader payout = Net trading profit x Trader's profit split
Firm's share = Net trading profit x (1 - Trader's profit split)
Suppose a trader uses $200,000 of the firm's capital and makes a net profit of $50,000 in a month after commissions. The agreed split is 70% to the trader.
Trader payout = $50,000 x 0.70 = $35,000.
Firm's share = $50,000 x 0.30 = $15,000.
The firm's monthly return on the capital it supplied is $15,000 / $200,000 = 7.5%, before the firm pays for technology, risk staff and the losses of other traders.Case study
Seen in the real world.
Redwood Capital Partners is an illustrative, fictional prop shop with 20 traders and $30,000,000 of its own capital. The founders believed their edge was skilled traders, and they gave each person a daily loss limit of $10,000.
In one quarter a talented trader began to ignore his limit, adding to a losing position in the hope of a recovery. The risk system froze his account automatically at the limit, which stopped what could have become a loss of several hundred thousand dollars.
The founders held a review and reinforced a simple rule: no trader is bigger than the risk limits. In the following year the firm's overall profit was steady, and the traders who respected the limits earned the highest payouts. The illustrative lesson is that a prop shop survives on risk control more than on any single great trade.
Watch out
Common mistakes.
- Assuming a prop shop trades clients' money, when it trades its own capital and has no client assets to protect.
- Joining a funded-trader programme without reading the fee, evaluation and payout rules, which can be strict and affect whether you ever get paid.
- Counting a profit split as the trader's whole return, without allowing for desk fees, data costs and the chance of hitting loss limits.
Questions
People also ask.
Is a prop shop the same as a hedge fund?
No, a hedge fund manages money for outside investors and earns fees, while a prop shop trades the firm's own capital and keeps the profit.
Can anyone become a prop trader?
Many firms recruit through tests and trial periods, and they look for discipline and risk control as well as skill, so beginners should expect to be assessed carefully.
Are prop shops risky?
Yes, because trading is difficult and many traders lose money, so you should only risk money you can afford to lose and be careful with fees and promises of easy profits.
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