From the moment a person begins to learn about finance, they hear the word trading everywhere. Trading is interesting and terrifying at the same time. While independent traders may try to carve out a niche for themselves in the marketplace, many others turn to prop firms. Proprietary trading firms or prop firms sell their market expertise and resources to individual traders wishing to make a name for themselves in the domain, and also provide them with capital which increases their profit margin. As obvious as it may seem, legal undertakings require due diligence to ensure a trader’s success.* In this article, we will study the legal boundaries concerning working with a prop firm, its terms of engagement, and why some call them the Best Prop Firms. We will also analyze the widely known 2 Step Challenge associated with prop trading.
How Does a Prop Firm Work?
An example of a prop firm is a proprietary trading firm that allocates capital for traders to engage in the financial stock market, from Forex, commodities, or even cryptocurrency. These firms generally market trade with incentivizing enormous leverages, which is bound to draw in traders as they are able to control positions greater than what their funds would otherwise enable. prop firms keep a share in the revenue obtained from the traders alongside the traders themselves.
It’s pretty self-explanatory – prop firms give out funds while traders offer their experience and skills in return for a fraction of the profits. However, these relationships come with a myriad of legal issues. With all of these legalities around it, there is a need to understand the conditions of any agreement before signing it.
Legal Framework Governing Prop Trading
Legal aspects of dealings with a prop firm will have many layers and will also differ based on where the firm and the trader are located. Simply put, the relationship between the trader and the prop firm is governed through contract law. Usually, there is an agreement made for different elements such as sharing profits, management of risks, adherence to the terms of trading, and how the firm deals with possible disputes.
Through this, traders engaging with prop firms need to be conscious of these agreements in addition to the legal considerations that accompany them. Notably, each firm may have different conditions so reading the contract carefully is paramount. Here are a few stipulations that should be top of mind for the contract:
- Profit-sharing ratio: the percent of profits the trader will earn from profitable trades.
- Fees and charges: Access to the capital of some firms, or participation in challenges like the “2 Step Challenge,” comes at a fee.
- Risk management rules: Routine limits set on how much risk a trader can take are referred to as risk management rules. These include stop loss rules, position sizes, and other similar factors.
- Termination clauses: These are the provisions which govern the rights and obligations of the parties upon termination by the trader or the firm.
Grasping these legal phrases goes a long way in avoiding legal misunderstandings and disputes in the future.
The 2 Step Challenge: A Trader’s Favorite
The “2 Step Challenge,” is arguably the most popular stage for aspiring prop traders at prop firms. A number of premier prop firms have their own testing procedures which they have come to refer to as the “2 Step Challenge.” The purpose is for traders to showcase their skills in trading and risk management prior to being awarded firm capital. It is usually broken out into two phases:
- Phase 1: In this phase, traders have to comply with predefined rules. The traders have to meet certain profit targets defined by the traders and set and follow their own rules on risk management. A common rule is set on maximum drawdown that the trader can suffer before being dropped out of the challenge.
- Phase 2: This phase typically includes stricter rules and a greater emphasis on demonstrating profitability within more difficult market environments. After a trader completes both phases successfully, they are given the privilege to trade the company’s capital.
From a legal perspective, the 2 Step Challenge often requires the trader to enter a contract whereby they accept the firm’s policies, such as risk management, timeline for achieving profit benchmarks, and other relevant stipulations. These terms must be understood as non-compliance may lead the trader to be eliminated from the challenge.
Although this challenge presents an excellent chance for traders who do not possess sufficient funds to trade independently, it also carries legal complications. Some prop firms impose entry fees that become forfeited if the trader does not complete the challenge. While these fees are usually disclosed, the trader must remain guarded against other undisclosed expenses. After successfully completing the challenge, traders should consider the payout policy as well.
Contractual Obligations in Prop Trading Agreements
Upon completing the 2 Step Challenge or entering an agreement with the prop firm, usually, traders are bound by a contract delineating the terms of engagement. Like any contract, this document contains terms that demand the trader’s attention since it has legal implications.
The most important elements of these contracts include:
- Profit Sharing: Most prop firms take a cut from the profits of successful trades executed by the trader. Prop firms compete for traders and as a result, the cut varies across the industry. In any case, it is prudent for traders to examine what portion the firm takes and most importantly, whether the contract has other unacknowledged charges or costs on top of revenues.
- Risk Management and Stop Loss Rules: Traders are subject to stringent risk control policies dictated by each Prop firm for the sake of the firm’s capital. Many firms operate with a ‘max drawdown’ rule which is to say that once a trader’s losses go beyond a certain point, they lose the capital or are otherwise disqualified from the competition. It is prudent to seek legal counsel with regard to obligations on risk management in order to be within the law.
- Trading Limits: Most prop firms establish specific trading limits with respect to the capital allocated to each trade by a trader. Breaching any of those limits could result in penalties or termination of the contract.
- Fees: In most cases, traders are required to pay a fee to take part in the 2 Step Challenge or to get funded by a prop firm. These fees differ from firm to firm and depend on the type of challenge. Other firms may also have platform and withdrawal fees or other fees.
- Dispute Resolution: Most contracts indicate how and if disputes are settled which includes if they would use arbitration or litigation in case there are conflicting disagreements. This section is very important for dealing with any disputes from the trader side and the firm, and understanding the legal steps will streamline the resolution process and reduce expenses.
The Regulatory Environment of Prop Firms
As opposed to a conventional financial institution or broker, proprietary trading firms do not operate under strict supervision because their environment is relatively unregulated. This is especially true for the United States. A number of these firms face some level of oversight from relevant bodies such as the SEC or CFTC, however, most prop firms do not fall under comprehensive regulatory supervision since they mainly use their own capital to trade and do not maintain clients’ funds.
Traders are not entirely without legal protection as they must still operate within the confines of the law. For example, fraud, misrepresentation, and market manipulation are illegal. Traders still need to be concerned about dealing with firms that operate in a reputable manner because there are some unethical firms that will take advantage of traders’ lack of understanding of the legal terrain.
Selecting the Most Appropriate Prop Firm: From A Legal Angle
It is at this stage where finding the best prop firms becomes tricky because traders want to achieve maximum profit. Firms need to pay attention to the legal protection offered above profit potential and other terms set by the firm. A proper firm must uphold its end of the bargain by providing working agreements, comprehensive trading policies, and an unbiased setup for the organization and trader. It is advisable for traders to conduct their due diligence on any prop firm under consideration and check reviews that ascertain their good standing and legal compliance.
Moreover, creating an account through a well-organized and appealing 2 Step Challenge helps achieve the professional marketing goals satisfying both entry-level traders and veterans. All participants in the challenge need to understand the rules, associated fees, and risks, so they can sustain the financial goals they have set for themselves.
Conclusion
Engaging with a prop firm provides traders with unique access to capital, making trading with increased volume possible. Like with any partnership, considering the legal dimensions of the firm’s setup will be fundamental for sustainability. Traders tend to overlook the details of contracts and agreements focusing on the profit sharing, liabilities and restrictions, and risk management policies of the 2 Step Challenge. Understanding the challenge alongside choosing a reputable firm with the correct legal documents will enable the traders to succeed in the uncertainty present in trading while being legally safe.