The purpose of this article is not to review the different proprietary trading firms and their programs proliferating the OTC/Futures market but to examine the merits of the latest craze from the perspective of someone who has worked in all segments of the trading industry.

I have been a professional money manager for more than 20 years, having worked as a proprietary trader for an investment bank and HNWI, a hedge fund manager, and for the last 12 years as an incubator of emerging traders.

The Real World

The hedge fund industry comprises roughly 15,000 hedge funds managing an estimated $5 trillion dollars, this includes CTA/Managed Futures managers. It is reported that about 6% of these funds close each year, with an overall average return of around 8% per annum if you take a long-term view of the industry.

Most importantly for our discussion, the fee structure is around 1% per annum management fee and a 20% performance fee above a high-water mark. I should add that managers' fees have been under pressure for years. Establishing a hedge fund or a regulated managed account is onerous from a regulatory point of view, as are the costs for establishing and maintaining compliance, along with auditing and administration fees.

To have any chance of raising sufficient money, the fund manager normally needs, at the very minimum, a 2-year track record, but more like 5-years, attractive risk-adjusted returns, and some previous firm and education pedigree.

The above is the formula required to play in the money management game with a reasonable amount of money under management. However, nothing is guaranteed. Many talented traders meeting the above criteria still struggle to attract enough attention or interest to raise sufficient funds to run a viable fund.

There are other forms of professional trading opportunities. This is where you formally become an employee of a bank or a proprietary trading firm managing the firm’s own capital. These are often highly sought-after positions that pay well, around 10% of profits.

In short, getting the opportunity to trade with sizeable capital is very tough. It is very similar to making a good living as a professional sportsman. The competition is fierce, and only a very small portion of people are trying to make it into the big leagues. Of course, we mainly see the successful ones as they are what the marketers focus on, exploiting the way our brains are wired to extrapolate the success of a small number into what we think is a much larger number.

Filling the Gap

The online trading craze that started in the 1990s with the burgeoning internet accelerated in the 2000s with the growth of the OTC market, which Finance Magnates readers are extremely familiar with and well-informed about. This growth has continued to date and spawned a massive industry.

I don’t have the space to describe the growth of this industry in detail, but one of the catalysts for the growth in the industry has been the incredible success of MetaQuotes (MT4 & MT5). The technology package this firm developed enabled companies with very limited technology and industry experience to set up a broker very easily and relatively cheaply.

The prop firm concept for retail-type traders has been around for many decades and is nothing new. It has been there to provide retail traders who wish to become professional traders a way to fill the gap where they lack access to capital and perhaps formal pedigree.

These prop firms usually required your physical presence, the purchase of their education package, and attached onerous trading rules that made it quite difficult to trade successfully, but for those who are able to adapt to the rules and trade profitably, this is a wonderful legitimate opportunity.

However, the marketing-savvy online retail trading industry has, over the last few years, witnessed massive growth in prop firms that, for a modest fee, offer you a relatively easy challenge and then the option to trade a decent sum of money and keep 80% of the profits you make while working from home. The temptation to make a decent living and be your own boss for a modest upfront payment was and is simply too tempting for almost anyone interested in trading.

Is it a Scam?

There is not an investor in the world who will give their money to someone with no trading pedigree to trade and let them keep 80-90% of the profits while they take all the risk. As discussed above, the industry standard for high-pedigree traders is between 10-20%. Whenever someone offers something way out of the norm, you should be concerned.

To begin with, the money the trader is trading is not real money. The firm offering the prop capital charges a fee, which they are banking on using to pay the small percentage of winners their inflated profit share. As soon as there are not enough new traders entering the system to cover the payouts of the winners, the firm becomes technically insolvent and unable to pay fees.

These new style prop trading firms have become victims of their own success. The demand for cheap capital to trade with a high payout is insatiable. With this increased demand, more and more prop firms have opened, increasing the competition for new clients. The increased competition has seen the costs of client acquisition grow, and the number of new firms opening without sufficient capital backing and expertise to manage the risk grow.

This has already led to a number of firms going bankrupt and more and more of these firms deploying unscrupulous behavior, such as denying profit payouts because of breaches of trading rules that are often not clearly made public to the trader or, even worse, made up on the go.

In essence, the business models of most businesses offering 80-90% profit share are unsustainable, and most will eventually go bankrupt, leaving clients with unpaid profit share. This part of the industry continues to become increasingly dodgy.

Final Thoughts

To use a trading analogy. The current wave of retail prop trading firms offering an 80% profit share is an excellent trading opportunity for a trader looking for more capital to trade. The downside is relatively small, like an option, as you can only lose the amount of money that a challenge costs.

If looking for increased capital is your goal I would stick to the well-known brands who have enjoyed a lot of early success as they are probably in the best financial position to continue to payout winners. Enjoy it will it lasts as it is simply not sustainable in its current form of paying out 80% of profits.

Next time, I will discuss what I think is a more sustainable model for traders looking for additional capital.