What Is a Prop Shop?
A prop shop, or proprietary shop, is a place where a large number of traders participate in the market using co-mingled money.
A prop shop is usually at a physical location where you combine your stake with all the other traders using the prop shop's facilities. Trades are made in stocks, bonds, commodities, and currencies.
The advantage of this setup is that as a trader you then have the ability to use the firm's buying power for your trades. This allows you to avoid having the minimum Securities and Exchange Commission requirement of $25,000 in your account to day trade and gives you 10:1 leverage or more on your stock and options trades. Day trading involves the buying and selling of a security on the same day.
The prop shop splits its profit with the trader. The opportunity exists for both high risk and high reward.
- A prop shop gives you access to a pooled amount of trading money.
- This eliminates the need for individual minimums.
- A good prop shop will educate you to become a better trader.
- It's easy to trade too much at a prop shop and overspend your account.
How Prop Shops Work
You could join a prop shop with $5,000. With a 10:1 leverage ratio, once you deposit your funds, you would then have the ability to day trade with no pattern day trading restrictions, as well as have access to up to $50,000 worth of leverage for your trades.
FINRA defines pattern day trading as the execution of four or more day trades within five business days and the number of day trades is more than 6% of the trader's total trading activity for that same five-day period. It also sets minimums on how much you need in your account.
Another aspect of a prop shop is that they will usually have state-of-the-art equipment and order entry platforms for traders to use. They generally offer education about the stock market and how to trade it.
Different prop shops offer different access to markets—some are global. Of course, nothing in life is free, and the benefits you get from a prop shop can come with a steep price.
Prop shops make their money in a number of ways, such as from margin balances and order flow. But they also make revenue from the ticket charges incurred by traders using their services. Sometimes the ticket charges cover the expense of a trading station and software, but those can also be charged a la carte depending on the firm.
If you are doing a large number of transactions each day on top of having to pay "rent" for your trade station and software at a prop shop, it can quickly eat into your account's profit and loss (P&L).
Criticism of Prop Shops
One of the key factors to consider when thinking about using a prop shop is what type of educational resources they provide. Many less-than-reputable shops don't care about customer longevity and only try to encourage traders to make as many transactions as possible—in order to generate the highest number of ticket charges.
In shops like this, there is a very high attrition rate as traders who are over-leveraged and inexperienced end up eventually blowing their accounts out.
In a reputable prop shop, there is an emphasis on continuing education for traders. The goal is to create a customer who is self-sustainable and can grow their account value over time, instead of just churning them for commissions. This education can even extend to one-on-one mentoring sessions where you can benefit from the knowledge of an experienced trader.
Though not for everyone, a prop shop can be a viable option for those who are more active traders in the stock market.
Types of Prop Shop Trading
Here are three types of prop trading:
A trader takes advantage of the price of a security and its theoretical futures price by buying the lower-priced security and selling the higher-priced security.
In this case, a trader uses the two merging companies' stocks and tries to buy and sell so that the price difference before and after the merger create a profit.
Traders analyze conditions around the world and make educated guesses about what will happen.