The Ultimate Guide to Proprietary Trading
This prop trading guide will be updated sporadically. Last updated September 2024.
What is a proprietary trading firm?
A Proprietary trading firm (or "prop firm") is a company, usually registered Broker-dealers, who engage in active trading with their own capital. Prop trading firms do not have clients and make trades on their own behalf.
What are the different types of prop firms?
Registered Prop Broker-Dealer
These firms are regulated by FINRA, the SEC, and other Self-Regulatory Organizations (SROs). This is most often PHLX. Deposits are required to be locked up for 1 year. BDs can charge commission. Registered BDs usually have Joint Back Office (JBO) arrangements with a clearing firm.
Every firm’s fee structure is unique so make sure you ask each individual firm. When you join a registered prop firm you become a professional and are subject to professional data fees. This is an unavoidable expense and can be costly, especially for lower capital accounts.
Other unavoidable fees are mostly related to trade execution; commissions, routing fees, SEC fees, TAF fees.
When joining a prop firm you become a member of the company. Member’s capital contributions that are designated as the company’s capital must be compliant with the net capital rules of the Securities Exchange Commission. As such, these contributions must meet the minimum one year contribution term under SEA Rule 15c3-1. This is where the standard 1 year lock up comes from.
What is a Joint Back Office “JBO” Arrangement?
A JBO arrangement is when a broker-dealer establishes a relationship with a clearing BD for custodial and clearing services. Reg T Section 220.7(c). allows for special margin treatment for BDs without clearing operations.1 A JBO participant must be a registered BD and is subject to net cap rules.2
“An arrangement may be established between two or more registered broker-dealers pursuant to Regulation T Section 220.7, to form a joint back office (“JBO”) arrangement for carrying and clearing or carrying accounts of participating broker-dealers.” - Finra Rule 4210
Unregistered Prop Firms
Unregistered Prop Firm do not require licensing but also are not regulated in the same capacity as Prop Broker Dealers. These firms should not be accepting any capital from its members. Additionally, some firms operate as unregistered broker dealers, charging commissions and/or giving leverage on accounts without being properly regulated. If a prop firm is not a broker dealer and does not require its traders to be registered and licensed, make sure to do your homework.
Prop Firm Models
Salaried
These firms are typically focused on Market Making, HFT, and quantitative trading. The career path to join a firm like this is getting a STEM degree from a target school, with an emphasis on mathematics and computer science.
In these firms, you typically start out in an entry-level operations role to learn the ropes. Progression varies widely amongst firms, but rarely are you ever an individual contributor. Compensation is salary, benefits, and usually a smaller portion of book P&L, typically 10-30%.
Note: I would love to provide more value here. If you are in this space and want to talk to me on/off the record, please DM me on Substack or the app formerly known as Twitter.
Unsalaried
There is a wide variety of unsalaried proprietary trading firm options. Some firms will offer a monthly draw for living expenses, payouts on backed deals and profit splits typically start around 40%. I have heard of monthly draws as high as $12k/mo with some firms requiring the trader make 110% of draw to be eligible for payout from trading profits.
Traders are either Class B or Class C members of an LLC and receive a Schedule K-1 or they are independent contractors and receive a Form 1099.
Training Firms
Training firms charge for their education and usually require the lowest capital contributions of any prop firm. These firms have the highest churn rates and higher fees, but allow people to not commit too much of their capital.
Training firms often make a substantial amount of their money on training fees and not on profit splits.
“Pay-to-Play” Trading Competition
It’s hard to even call these prop firms, I refer to their business model as Trading-as-a-service (TaaS). The model is you pay a monthly subscription to demo trade. As you progress through their structure you pay more money per month and get more buying power. The structure is often intentionally restrictive to force churning of accounts and play on the gambler’s fallacy and near-miss effect of wannabe traders.
Offshore “Prop” Firms
A lesson from Nonko Trading. Nonko purported itself as an unregulated offshore prop firm. To attract day-traders, Nonko offered terms that were not available at any registered BD in the US, including a minimum deposit of $2,500 (and occasionally lower), as well as leverage of 20:1. Nonko charged it’s traders a commission rate at or below $0.006 per share.
The operators of Nonko secretly provided customers with training accounts instead of real ones, allowing them to misappropriate customers’ trading deposits without detection. Internally, they referred to the scheme as their “TRZ” program”, named after the TRZ prefix of paper trading accounts3. All told, this brokerage Ponzi scheme stole over $1.4m from customers.
I had my own run-in with them when I tried to acquire JC Trading Group in 2018, for obvious reasons (my initials) I wanted the name, and to this day I am still mad about this. During negotiations, I went on vacation and one morning someone handed me a newspaper with a story reading "SEC charges 2 Oakland County men in $1.4M fraud case"4. I immediately emailed Chris that I would not be pursuing purchasing his domain any further, to which he replies “I understand. I wouldn't have put you in a bad position. Just so you know.”
sure. 🙄
I recommend avoiding offshore prop firms if you live in the US.
Pros and Cons of Trading at a Proprietary Trading Firm
Pros
Access to capital. Such a short sentence shouldn’t be overlooked. Traders are allocated hard buying power compared to margin. You can easily get 20:1 buying power intraday on your capital contributions. This opens the door to all kinds of more capital intensive strategies.
Simplification of Taxes. Filling a K-1 is significantly easier than dealing with a trading tax professional (and paying the “trader tax” fees associated with that).
Collaboration. The cool thing about being on a desk is the different approaches towards trading you see. One guy might be trading merger arb while another is trading imbalances. Firms very wildly on how much collaboration they have.
Support. Tech support, risk, management. They’re all there for you and they are your partners. Treat them well and they’ll help you out.
Technology. I think this is slowly becoming less true. But I will add it was a lot of firms still have their own proprietary technology.
Cons
Comingling of fund. Since capital contributions are used for net cap. Your capital is exposed to being lost by other traders at the firm. Generally speaking, risk managers stay on top of loss limits and exposure, but black swans have taken firms down to their knees or shuttered doors completely. A story for another time.
Restrictions. Being a registered representative of a firm means you have certain restrictions. Outside business activity needs to be disclosed, outside brokerages may not be allowed. Additionally, employment agreements may be overly restrictive or have claw back provisions. In one egregious contract, the trader was restricted from working “anywhere in North America” for a period of time after termination of employment. Without compensation, I doubt that is even enforceable today.
Licensing. Studying and taking the Security Industry Essentials (SIE) exam and then the Series 57 Top Off can be intensive, especially if you are already actively trading.
How to Research Prop Trading Firms
Step 1: Visit their website.
Take notes on what they do. What is their focus? What is their business model?
Step 2: Look them up on BrokerCheck. This is the most powerful resource you can have for researching a firm. BrokerCheck will give you a detailed report on each broker and broker dealer. The detailed reports will disclose:
● When the firm was founded
● History of the firm and its direct owners and executive officers
● What SROs they are registered with
● Types of business they engage in
● Who their clearing & introducing arrangements are with
● Details of regulatory events
Step 3: Check EDGAR
The SEC requires that all broker-dealers file Financial and Operational Combined Uniform Single (FOCUS) Reports. The FOCUS report can give you a snapshot of a firm’s financials. Only the annual reports are
Step 4: Reach out to the firms
You are deciding what firm is best for YOUR needs. Are their interests aligned with your interests? Not only should you find the best monetary deal, but also you need to be able to trust and like the people you are doing business with.
Step 5: Compare offers and firms and choose the best fit for you!
U.S. Government Publishing Office. (n.d.). Regulation T: Credit by brokers and dealers (12 CFR Part 220). Electronic Code of Federal Regulations. https://www.ecfr.gov/current/title-12/chapter-II/subchapter-A/part-220
Financial Industry Regulatory Authority. (2003). Notice to members 03-68: FINRA reminds firms of their obligations under NASD Rule 3510 following the recent power outage. https://www.finra.org/sites/default/files/NoticeDocument/p004001.pdf
U.S. Securities and Exchange Commission. (2017). SEC v. Naris Chamroonrat, Yaniv Avnon, Ran Armon, G Six Trading Y.R Ltd., and Adam L. Plumer, amended complaint (No. 2:16-cv-09403-KM-JBC). United States District Court for the District of New Jersey. https://www.sec.gov/files/litigation/complaints/2017/comp23830.pdf
SEC charges two men with fraud in fake trading accounts scheme. U.S. Securities and Exchange Commission. (n.d.). https://www.sec.gov/newsroom/press-releases/2018-178