Prop trading, or proprietary trading, is a unique business model in the financial world where companies invest in talented traders by entrusting them with the management of their capital. This business model offers aspiring traders remarkable career development opportunities, eliminating one of the biggest barriers to entry—the need for significant personal capital.
The modern prop trading market provides the opportunity to trade a variety of financial instruments. Traders can specialize in trading CFDs (Contracts for Difference), which allow price speculation without owning the underlying assets. Another popular option is futures contracts, enabling trading in both commodity and financial markets. For more traditional investors, stock trading is also available, though it is less commonly offered by online prop trading firms.
The Specifics of the Prop Trading Market
The current landscape of prop trading is dominated by firms specializing in CFD trading. This dominance is primarily due to economic factors—CFD trading requires minimal investment in technological infrastructure, and market data access costs are relatively low. The second major segment is firms specializing in futures trading, where traders must account for additional costs such as market data access fees and specialized software licenses.
The least common (at least in remote models) is prop trading in the stock market, even on major exchanges like NYSE or NASDAQ. This is largely due to the high costs of accessing market data and professional trading platforms like Sterling Trader Pro, which significantly impact the profitability of this business model.
2-Step Trading Challenge
The recruitment process in prop trading firms has evolved into a 2-step trading challenge model. This system allows for an objective evaluation of potential traders’ skills before entrusting them with the firm’s real capital. While this is the most popular model, there are also one-step programs and instant funding options available. As one might expect, obtaining capital faster typically involves additional costs.
Focusing on the 2-step challenge, the first stage is a basic test where the trader must demonstrate their skills by achieving a specified profit target while adhering to strict risk management rules. The second stage, often referred to as verification, serves to confirm that the results achieved in the first stage were not a matter of chance and that the trader can consistently generate profits.
Key Challenge Parameters
Profit Target
The profit target is one of the main criteria for evaluating a trader's performance during the 2-step challenge. Typical requirements are:
8–10% of the account value in the first stage.
4–5% of the account value in the second stage (verification).
The profit target is calculated based on the initial account balance (balance-based), meaning that open positions do not impact the calculation of the required profit amount until they are closed. This ensures that participants do not need to worry about volatility caused by open positions as long as they remain active.
Daily Loss Limit
The daily loss limit is a crucial risk management parameter that prevents excessive losses during a single trading day. Typical requirements are:
4–5% of the initial account value.
Calculation Method: The daily loss limit is determined based on the balance (balance-based) at the end of the previous day. This value is then compared to the current performance on the account, including both closed positions and open profit or loss (floating P/L).
Impact of Open Positions: If the participant holds profitable positions, they may introduce some flexibility, but in the event of a sudden market reversal, there is a risk of quickly breaching the limit. For losing positions, the floating loss is immediately factored into the current loss calculation, reducing the tolerance for further losses within the day.
Total Loss Limit
The total loss limit is a mechanism that caps the maximum allowable loss on the account throughout the entire challenge process. The three most common types are:
Balance-Based Drawdown The limit is calculated based on the initial account balance, e.g., 10% of the total value.Example: On an account with an initial balance of 100,000 units, the loss limit is set at 90,000. Regardless of the profits achieved, this limit does not change.
Equity-Based Drawdown The limit is based on the current equity value, including both closed positions and open profit or loss. This model better reflects the trader’s real-time performance but requires greater discipline to avoid sharp market movements that could affect the floating P/L.
Trailing Drawdown This dynamic limit adjusts as the account balance increases. Each new peak in equity sets a new minimum allowable level.Example: For an account with a trailing drawdown of 10%, the initial balance of 100,000 has a loss limit of 90,000. If equity rises to 110,000, the loss limit moves up to 100,000.
Impact of the Trailing Mechanism:Profits are protected, but the mechanism also restricts the trader’s flexibility to take additional risks as the account grows.
Additional Restrictions
Prohibition of Trading During Major Economic News Releases
Firms often require traders to avoid opening positions during the release of macroeconomic data, such as Non-Farm Payrolls (NFP), interest rate decisions, or inflation reports.Objective: To protect against sudden market movements that could lead to uncontrolled losses, especially in highly volatile markets.
1–2% Risk Per Trade Rule
This requires limiting the maximum risk on a single trade.Example: For an account worth 100,000 units, the maximum allowable loss per position is 2,000 units.
Objective: To reduce the impact of a single unsuccessful trade on overall performance.
Closing Positions by End of Day (Day Trading Accounts)
This rule applies to day trading accounts, where all open positions must be closed before the trading session ends.
Objective: To mitigate risks associated with unexpected market movements outside trading hours.
Closing Trades Over the Weekend / Holding Positions (Swing Accounts)
Swing trading accounts may allow positions to remain open over the weekend but often require additional safeguards, such as higher margin requirements.
Objective: To reduce the risks of price gaps when markets reopen after the weekend.
Mandatory Stop Loss
Every open position must be secured with a stop-loss order to minimize losses in case of sudden market reversals.
Typical Requirement: Stop-loss levels must not exceed the maximum allowable risk per trade (1–2% of the account).
Tools and Indicators for Evaluating a Trader's Strategy
To succeed in the 2-step challenge and the verification process, it is crucial to adhere to the basic rules. A trader must achieve the required Profit Target without breaching the Daily Loss Limit or the Total Loss Limit. However, some prop trading firms may impose additional requirements, such as the mandatory use of Stop Loss for every trade.
Beyond meeting the formal requirements, evaluating and improving a trader’s strategy requires analyzing additional indicators. Below are the most commonly used metrics with explanations:
Win Rate
Definition: The percentage of winning trades relative to the total number of trades.
Application: A high Win Rate suggests that a trader's strategy generates a significant number of profitable trades.Interpretation:
A high Win Rate (>60%) can be beneficial but may also indicate that the trader holds losing positions for too long, negatively impacting the overall profitability of the strategy. In such cases, it is useful to analyze this metric in conjunction with the average loss per trade (see point 3).
Average Profit Per Trade
Definition: The average amount of profit generated by a trader on a single profitable trade.
Application: Helps evaluate whether the trader is closing positions too early, potentially limiting profits.
Interpretation:
A low value, combined with a high Win Rate, may indicate a tendency to close profitable positions too early, which is especially detrimental if the strategy is not designed for scalping.
Average Loss Per Trade
Definition: The average amount of loss incurred on a single losing trade.
Application: Enables the evaluation of how effectively the trader manages losses, including how quickly they close unprofitable positions.
Interpretation:
A high value may suggest that the trader is holding losing positions in the hope of a reversal, increasing the risk of breaching the Total Loss Limit.
A low value indicates swift loss-cutting, aligning with sound risk management principles.
Risk-to-Reward Ratio (RRR)
Definition: The ratio of potential profit to potential loss on a trade.
Application: Evaluates whether the trader’s strategy has a favorable profit structure relative to the risks taken.
Interpretation:
A standard RRR is 1:2, meaning the trader risks 1 unit to gain 2 units.
A value below 1:1 indicates excessively high risk relative to potential gains and necessitates strategy analysis and optimization.
Maximum Drawdown
Definition: The largest difference between the peak account value and the lowest value during a given period.
Application: Helps determine the extent of losses a strategy may incur in the worst-case scenario.
Interpretation:
Low drawdown (e.g., <10%) indicates a stable strategy.
High drawdown (>20%) may signal that the trader’s strategy is overly aggressive and requires better risk management.
Sharpe Ratio
Definition: A metric evaluating the return-to-risk ratio, with higher values indicating higher returns relative to the risk taken.
Application: Helps compare different strategies based on their efficiency.
Interpretation:
A value above 1 is considered good, while a value above 2 is deemed very good.
Consistency Score
Definition: A metric assessing how frequently a trader achieves stable results over a long period.
Application: Verifies whether the trader’s results are skill-based rather than luck.
Interpretation:
Traders who maintain consistent levels of profit and loss are more reliable than those who achieve profits in one month but incur significant losses in another.
Summary
The 2-step trading challenge has revolutionized how prop trading firms recruit and verify new traders. This system enables an objective assessment of skills while teaching future traders discipline and proper risk management. Success in this model requires not only analytical skills and market knowledge but also the ability to consistently adhere to strict risk management rules.
The key to success lies in thoroughly understanding all the rules before starting the challenge, consistently adhering to risk limits, and focusing on long-term result stability. While the requirements may seem strict, this system effectively identifies traders capable of generating stable long-term profits, which is the cornerstone of trading success.
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