How Do Prop Firms Make Money?
For some traders, prop firms can seem too good to be true. Where does the money come from? Are these demo accounts? Do you ever see the profits? Does anyone ever get funded?
There is so much mystery surrounding prop firms since the industry massively expanded over the last few years. In this article, we are going to take a look behind the curtain and see exactly how prop firms actually make their money.
There are two business models for prop firms. The first is the challenge model, where traders pay to take a trading challenge, which most fail – this provides revenue to pay profitable traders. The second model is the profit split model, where the prop firm takes a cut of the profit traders are making each month, in exchange for providing the trading capital.
How Do Prop Firms Make Money?
There are many prop firms in the industry now, but the majority of them are following the same business model. Prop firms are usually fairly elusive and not too willing to divulge exactly how they are making a profit or where all the liquidity for funded accounts is coming from.
Being one of the industry-leading prop firms ourselves, we feel able to provide an interesting insight into how, we and the rest of the industry, are making money. There are 2 business models that prop firms use to make money. We follow the profit split model, which we will dive into later in this article. The overwhelming majority of prop firms are following the challenge model. Although very popular, there is a range of issues, we believe, with this business model.
The Challenge Model
As mentioned above, the most common business model for prop firms is the challenge model. This is where the prop firm will sell a trading challenge to a trader. This will cost the trader a fee. Usually, if the trader manages to pass the challenge and receive a funded account, the fee will be refunded! We don’t operate this business model because there are some inherent problems, in our opinion. Firstly, the prop firm is now making money from traders failing. In fact, it’s in the best interest of the prop firm for the majority of the traders to fail – so they will never request withdrawals. This isn’t how prop firms in other industries work, but it appears to be the norm in the forex industry. Profiting off failing traders influences some prop firms to create very strict trading rules, knowing that 90% of traders are going to fail to fit within the tight rule set. This provides the same issue as offshore/B book brokers – where the firm can trade against traders!
This is one of the main reasons why prop firms’ challenges are so hard to pass.
Not only that, this type of prop firm doesn’t fund profitable traders with real capital – instead, they use demo accounts. If the trader happens to be profitable and requests a payout, they’re paid out by the capital from unprofitable traders failing the challenge. In this sense, these firms operate in almost a Ponzi-like manner. Most traders aren’t aware of this. We certainly aren’t discrediting other firms, but it’s important to understand how you’re actually receiving the profit split on your funded account. If too many traders make too big a profit, money can run out.
The Profit Split Model
The original prop firm business model, and the model we operate, is the profit split model. In this business model, it’s in the firm’s best interest to have profitable traders. Take Lux Trading Firm, for instance. We only get paid by profitable traders. We take a profit split every month, every time a profitable trader takes a withdrawal from their funded account. This means that if a trader fails to be profitable – it doesn’t generate any revenue for us. This is where the difference lies, as it’s in our best interest to actually grow and retain profitable forex traders. Not only that, traders are using real trading capital with Global Prime – so any losses they incur will also be felt by us.
The issue with this business model, for prop firms, is that there are a huge amount of unprofitable forex traders and traders that are incapable of sticking to a fixed risk setting. This is why we created the Lux Elite Traders Club. Since we need profitable traders, we need to help get traders profitable – so we do! By utilizing our daily live trading room, audits from KPMG, 1-on-1 mentoring calls, risk desk, and analytics from Trading Central, we’ve seen an increase from 4% of traders getting funded, to nearly 20%! Of course, we are biased, but it’s very important to ensure that the prop firm you work with is paid from your successes, not your failures!
Where Do Prop Firms Get Their Money?
One question that traders are always asking is ‘where does the money come from?’ or ‘are forex prop firms a scam?’. This is a great question and one that all traders really need to be aware of before selecting which funding option is best for them.
Prop firms using the challenge-based model are typically cash-rich from traders failing their challenges. They are usually built as quite small operations without any kind of institutional backing and lack the infrastructure that many FIs have. On the contrary, prop firms that purely make their revenue from profitable traders are typically heavily invested in, or even funded by, venture funds. This is due to the fact that prop firms like Lux Trading Firm need a huge amount of liquidity to provide to traders.
There’s no value for us having profitable traders trading on demo accounts, as this doesn’t make us any money! So prop firms that use the same business model as us will need to have huge volumes of capital at hand, ready to offer to budding traders.
In Conclusion, there are 2 ways for prop firms to make money
Either from traders failing, or from traders succeeding and splitting profits with them.
At Lux Trading Firm, we are only getting paid by successful traders, so we built the Elite Trading Club to increase our amount of profitable traders! With the support provided, we’ve managed to 5x our funded traders, and we are seeing more successful traders than ever.