Inside Scoop: Is Retail Prop Trading a Ponzi Scheme?

The collapse of another major  retail prop firm has sent fresh shockwaves through an industry whose business model was already being questioned.

This has some calling it a Ponzi scheme. While this may be a reach given the definition of a Ponzi scheme, there are some similarities that have raised concerns over the retail prop trading industry.

What Is a Ponzi Scheme?

A Ponzi scheme is an investment scam that pays early investors with money taken from later investors to create an illusion of big profits. A Ponzi scheme promises a high rate of return with little risk to the investor. It relies on word-of-mouth, as new investors hear about the big returns earned by early investors. Inevitably, the scheme collapses when the flow of new money slows, making it impossible to keep up the payments of alleged profit…Investopedia

The Prop Industry Business Model

The prop industry-wide business model is to use money earned from paid trader challenges to fund the rest of the business.

This includes spending on marketing as prop firms need a constant flow of new clients to fund its business. It also includes revenue to cover the unlimited risk posed by those funded traders who trade profitably and share in the profits. The reason I say unlimited is the payout to the profitable trader can be as high as 90% of trading profits. The prop firm is on the hook for the share of the profits paid out. Note in both the challenge and funded phases, the trader trades with virtual money (i.e. a demo) and not with a real money account.

The reality is that the rules and restrictions imposed by prop firms make it difficult for traders to pass the challenge test phase and stay in the funded phase if they pass as well. The failure rate of traders who take the challenge and those who ultimately get funded is said to be overy high (some say as high as 90% fail for both).

Prop firms are counting on failure. It collects fees whether a trader passes or fails a challenge test. The more who wash out in the funded trader phase, the less risk to the prop firm. This is a key to its business model. This may be why it is likened to a Ponzi scheme.

This raises more questions than answers.

Does this make it a Ponzi or just a questionable business model counting on traders to fail and drop out of the program?

Is it a Ponzi because both challenges and so-called funded accounts are only trading with virtual money?

Is it a Ponzi because prop firms need a constant flow of new challenge accounts o fund the funded accounts part of the business?

While the fact that a prop firm’s interests are in conflict with those of its trader clients, technically the answers to these questions do not meet the definition of a Ponzi scheme. In addition, not all prop firms operate and are managed in the same way. ,

The firms that come closest to a Ponzi are those who or are either undercapitalized or just greedy. They rely blindly on revenue from new trader challenges to fund the risk of funded accounts making money. The plan is to make more money from failed challenges than the amount paid out to profitable funded traders. They are counting on a very high percentage of traders failing and then trying again. They are also counting on funded traders failing as well.

What about others?

I assume there are prop firms who want to be in it for the long haul by managing their risk. While I am not privy to the way prop firms operate, and without going into details, it would make sense to find ways to hedge the unlimited risk of paying out to profitable-funded traders.

There was a time when some prop firms claimed to fund funded accounts with real money. This practice ended when prop firms, in an effort to avoid regulatory scrutiny, went to a full virtual trading program, that did not involve real money trading. One exception I have seen is Lux Trading Firm, which claims to set up real money-funded accounts for those who pass its challenge.

Is there a place for prop trading?

To be clear, I am not endorsing retail prop trading. However, it offers a place for those traders who are enticed by the opportunity to get a large (virtual) funded account by paying a fee to sign up for a trading challenge. This is okay as long as they go into it with their eyes wide open by being aware of how prop firms operate and are willing to accept the risk of failure with eyes on the reward.

If you plan to take a prop firm’s challenge:

• Open your eyes and don’t be blinded by the lure of getting funded
• Not all prop firms are the same.
• Do your due diligence.
• Ask questions
• Read reviews by traders, not sites promoting prop firms.
• Accept the fact that there is no free lunch in the trading world and that the deck is stacked against you. It is how the prop business model works but some might say that is true for trading in general
• Be wary of those firms who water down their rules to make it easier to pass. These firms might be in need of cash and are willing to mortgage their future by getting customers to sign up with easier terms only to find themselves with a greater risk if more traders pass the challenge.
• Remember, this is not a regulated industry. Any prop firm can put up a neat website and promise the moon but only deliver melted cheese. Cheaper is not always better. Avoid those that come closer to a Ponzi.
• Look for those prop firms that manage their risk and run the program as a business.

To sum up, while it does not meet the strict definition of a Ponzi scheme, even the fact that a prop firm is being compared to one should raise questions. From a trader’s perspective, the decision to take a prop firm’s challenge is up to you but before going ahead do your due diligence. Whatever you decide, all you can ask for is if you pass the challenge and trade profitably you will be paid out for your efforts. If you choose to go ahead, do your due diligence and don’t proceed with your head stuck in the sand.

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