Prop Trading Strategies

In proprietary trading or “prop trading”, a trader uses the capital provided by a firm to execute trades with the profits shared between the trader and the firm. In this way, prop trading provides another way to make a profit from market returns without using the trader’s own capital, albeit with some differences compared to being a day trader.   

Becoming a successful prop trader, however, isn’t without its challenges. Prop traders are required to pass a prop trading challenge before they can get the opportunity to trade funded accounts. It is estimated that only a fraction of the traders who take the challenge actually pass ^[1]. 

What is a Prop Trading Test or Challenge? 

A prop trading test (or challenge) is an evaluation where a trader has to prove they have the necessary skills and talent to trade the funds provided by a proprietary firm.  Different prop trading firms have varying requirements for their tests, with some requiring traders to pass multiple stages before they qualify for a funded account. Some firms may also offer a demo or simulated account for applicants to trade in a risk-free environment.  

Are these tests hard to pass? Yes. These challenges are designed to thoroughly assess a trader’s skills and consistency. To succeed, you must have a strong command of trading strategies and risk management. However, with the right preparation, you can significantly increase your chances of passing the challenge.

Proprietary Trading Flow/Process 

Passing the prop trading tests puts you in a highly competitive environment where you are expected to consistently meet your assigned trading goals. At the same time, you are expected to avoid hitting the total loss limit (known as the drawdown limit) set by the test, a feat that requires a thorough understanding of risk management. Exceeding the drawdown limit could lead to disqualification or account closure, ending your bid to become a prop trader.  

While it might sound stressful, succeeding at a prop trading test entitles you to a share of the returns generated by your winning trades. This will also pave the way to trade larger funded accounts. Here’s what the end-to-end process looks like: 

1. Capital Allocation: The firm provides the trader with options of initial balance. 

2. Strategy: Traders are required to meet profit goals periodically. For this, they conduct their research and come up with trading strategies. Traders are usually given access to high-quality trading tools by the firm. 

3. Trade Execution: The traders execute trades using the capital provided by the firm. This could involve buying and selling forex and CFDs of stocks, bonds, commodities, or other financial instruments. 

4. Risk Management: Traders are required to implement risk management strategies to control losses. They must ensure they do not exceed the daily and total loss limits set by the prop trading firm to avoid forfeiting their accounts. 

5. Performance Analysis: In order to ensure profitability, the prop firm keeps an eye on the performance of traders. As a prop trader proves their profit-making ability, the firm may adjust their risk percentage and fund allocation over time.  Seasoned traders also get the opportunity to get a bigger share of the profits eventually. 

Preparing for a Prop Firm Test 

Succeeding at the prop firm test is crucial if you are serious about embarking on a career as a prop trader. Since this is an evaluation of your trading capabilities, you’re expected to apply the best trading strategies and consistently achieve profitable trades.  

To increase your probability of passing the prop trading test, here are some aspects to focus on: 

• Strategy and analysis – Technical analysis is arguably the most crucial tool for a trader. Knowing how to read and interpret an asset’s price chart and understanding the relevant technical indicators to apply is essential in estimating price movement in the short term. Utilising moving averages, Relative Strength Index (RSI), and Bollinger bands can help traders make sense of market volatility and take appropriate steps in response. Additionally, fundamental analysis should not be neglected, as it can provide context and background to foster an understanding of an asset’s behaviour and provide clues to upcoming trading opportunities.  

• Control over emotions – Prop trading is all about maintaining discipline and composure. Markets may exhibit unpredictable behaviours at times, and it is important to learn to manage your emotions effectively when things don’t go according to plan. Be wary of acting out under pressure as that can lead to a spiral of poor decisions.  

• Risk management – When trading in financial markets, a certain level of risk is to be expected. The key is to focus on preventing substantial losses by following a solid risk management strategy. If leverage is provided, be judicious in its use and bear in mind its ability to increase both potential returns as well as losses. Sustained success in prop trading hinges on effective risk management and a deep understanding of the tools and resources at your disposal.  

• Challenge simulation – Prior to attempting the test, thoroughly familiarise yourself with the prop firm’s targets, trading parameters, and rules. Utilise this information to simulate the challenge in a demo account, aiming to maximise your profitability while carefully considering all relevant variables. 

How to Pass the Prop Trading Test  

If you’ve prepared well and have confidence in your skills, you only need discipline and a thorough trading plan to succeed. Staying consistent and adhering to your plan is essential. Do not forget to employ appropriate risk management strategies as well. The ability to manage and recover from drawbacks can be a major deciding factor in whether you pass the challenge or not.  
 
That being said, there are strategies prop traders can consider to minimise risk and foster decent returns, such as scalping and arbitrage. Combining these strategies with advanced trading tools helps traders to accurately trade the market and minimise losses. Here are a few strategies to help traders effectively manoeuvre through the prop challenge:  

Winning Strategy 1: Pairs trading ^[2]  

Pair trading is a popular trading strategy among seasoned traders, first introduced in the 1980s by Morgan Stanley. The strategy aims to seek out market-neutral profits by trading pairs of closely related assets.  

When the correlation between the two breaks down, a long position is taken on the underperforming asset, and a short position on the overperforming asset. As the correlation is restored, the trader benefits from both positions.  

Succeeding at the pairs strategy requires the ability to identify suitable asset pairs with a high statistical correlation of at least 0.80. While traders can refer to historical data to identify such pairs, the correlation may not bear out in future price action.  

Winning Strategy 2: Arbitrage 

Arbitrage is the act of capitalising on discrepancies in the market. These opportunities arise when there is a discrepancy in an asset’s price in different markets. Since these discrepancies are small, arbitrage trades yield smaller profits. However, this also means that the risk involved is less.  

Because arbitrage opportunities may be fleeting, prop traders utilise bots and market-watching tools to find these opportunities and execute them at extreme speeds. However, some prop challenges do not allow the use of trading bots, so you should check to make sure using bots won’t result in a disqualification.  

Two popular arbitrage strategies include index arbitrage and volatility arbitrage. Index arbitrage attempts to exploit the discrepancies between ETFs or futures and underlying stocks. Meanwhile, volatility arbitrage revolves around identifying discrepancies in implied volatility and actual volatility in the options market. 

Winning Strategy 3: Short Interval Trading 

Short-interval trading strategies like scalping and day trading are especially common among successful prop traders. The idea is to capitalise on price fluctuations inherent in the markets and carry out multiple trades throughout the day, each spanning a few seconds to a few hours. Traders seek to profit from minute price movements and accumulate several wins over the trading day.  

The strategy demands precise timing, quick decision-making, and access to complex trading tools. This trading approach is highly competitive and intense, requiring rigorous risk management and disciplined execution to minimise losses. 

Winning Strategy 4: Opening Order Strategy ^[3] 

In this prop trading strategy, the idea is to take the same side of the trade as the New York Stock Exchange (NYSE) specialist during the opening of the market.  

Since the NYSE specialist is responsible for maintaining an orderly market by matching buy and sell orders, it can be assumed that the specialist’s actions reflect their assessment of the market sentiment and potential price movements.  

Hence, prop traders align with the specialist’s actions in the hopes of capitalising on the anticipated direction of the market at the opening bell. 

How to Manage Your Risk in a Prop Trading Test? 

When managing risk in a prop trading test, the same foundational principles apply as if you were managing risk on your own trades. Understanding drawdowns is essential to effective risk management, which aims to minimise potential losses while maximising gains. In proprietary trading firms, risk management encompasses several key components: 

Risk Management Strategy 1: Establishing Capital Limits to Safeguard Your Trading Capital 

During a prop trading challenge, you may be given a much larger capital than you’re used to trading with. It is important not to give in to greed and become overconfident.   

Strive to apply the same principle of limiting your capital-at-risk per trade to, for example, 1% or less. This will help prevent a string of losses from depleting the account and potentially disqualifying you from the challenge.  

Limiting your risk-per-trade also encourages a more analytical approach to trading, reducing the emotional decision-making that often leads to significant losses. 

Risk Management Strategy 2: Implementing Stop-Loss Orders to Control Losses 

Stop-loss orders are a crucial risk management tool that automatically sells an instrument when it reaches a specific price, thus limiting the loss from a losing trade. By setting a stop-loss, traders can ensure that their losses are contained within manageable limits, even if the market moves abruptly against their position. This mechanism helps preserve capital and heads off the temptation to stubbornly hold on to a bad trade.  

Risk Management Strategy 3: Setting Take Profit Orders to Secure Gains 

Take profit orders are designed to lock in profits by automatically closing a trading position once it reaches a predetermined profit level. This strategy ensures that gains are realised before market conditions can reverse, safeguarding returns from sudden downturns. Implementing take profit orders allows traders to establish clear targets for each trade. This reduces the temptation to hold on to excessive gains, which can lead to potential losses. 

Risk Management Strategy 4: Diversifying Your Portfolio to Mitigate Risk 

Concentrating all your exposure to a single asset can create huge risks. So, diversifying assets that you trade in different markets can reduce the risk exposure of your portfolio. By not concentrating all your trading capital on a single asset or market, you effectively reduce the impact of poor performance in any one area on your overall portfolio. 

Risk Management Strategy 5: Mastering Emotional Control for Disciplined Trading 

Maintain discipline by adhering to the trading plan and risk management rules, regardless of market conditions. This will go a long way in avoiding decisions driven by fear or greed. Developing this level of emotional control requires regular practice and self-awareness. Keeping a trading journal and reviewing your outcomes regularly can help you learn from your mistakes while identifying emotional triggers.  

4 Common Mistakes When Taking Prop Trading Tests 

Prop trading tests present high-pressure situations, especially for newbies. This increased pressure may lead to mistakes that a trader wouldn’t usually make. Here’s a list of four common mistakes to be aware of while taking the test. 

1. Inefficient risk management: One of the main reasons why newbies fail their trading test is forgetting to implement risk management strategies. Always use stop-loss and take-profit orders to ensure profitability while minimising risks. 

2. Revenge trading: Markets can exhibit illogical behaviours, inflicting unexpected losses on your positions.  The worst way a trader can respond is to enter new positions without carrying out proper analysis, hoping to recoup their losses. Instead, take a moment to recenter yourself, reevaluate your assumptions and start a new trade with a clear mind.  

3. Inconsistency and impulse: Always create a strategy and a trading plan and adhere to it. Getting distracted by other market opportunities leads to impulse trades which could disrupt your trading plan and reduce your probability of success.  

4. Over-leveraging: Over-leveraging is a significant risk factor in trading that occurs when a trader uses borrowed funds or derivatives to increase the potential return on investment. While leverage can amplify gains, it can equally magnify losses, leading to potentially catastrophic outcomes. Always approach leverage with caution, and when in doubt, remember that slow and steady wins are always superior to wild, speculative bets.  

If you’ve nurtured your skill and have mastered risk management, consider yourself ready for a prop trading test. The points that ensure success are emotional stability, discipline, risk management, and the willingness to learn over time. That being said, Vantage Elite is welcoming talented traders to take its test and begin their careers as prop traders. If you’re ready for the challenge, join the Vantage Elite Challenge today! 

Prefer the flexibility of online trading? You’ll find everything you need to succeed, and more, with Vantage. Sign up for a live account to start trading, or test out our powerful platform with a demo account.  

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