Why Difficult Challenges are Essential for Prop Firms & Traders

Recently I shared a tweet discussing some of my thoughts about the rapid improvements to prop firms. There is a risk for both firms and traders as challenges continue to get easier and easier.

In this post I’ll explain how prop firms actually make money, and why this means both firms and traders should want prop firm challenges to be difficult – or they risk ruining the prop firm experience for everyone.

The Online Prop Firm Model

Online Prop Firms, offer capital to any trader who passes their evaluation challenges. This capital comes in the form of a ‘funded account’, where the funded trader is eligible for a profit split from the returns they make on the account.

Traders who want to get funded have to pay to take part in an evaluation, (challenge is another word for the prop firm evaluation process) with the price depending on the account size. For example with My Forex Funds a $10k account costs $84 while a $100k account costs $499. This goes all the way up to $300k accounts which cost $1,389.

While the amount of trading capital available for the price may seem too good to be true, the challenge that traders must pass before getting funded is what allows this prop firm model to be profitable. FTMO, the first ‘mainstream’ online prop firm has a 2-phase challenge process. First, a profit target of 10%, then a 5% target.

While these may initially seem like fair targets, the drawdown rules that FTMO and other prop firms implement are what makes the challenges much harder to pass.

FTMO has 10% maximum drawdown, where the account is lost if this rule is breached. This effectively makes the phase 1 profit target of 10% a required return of 100% of the account’s drawdown. For example on an $100k account, you must use the $10k of drawdown to make $10k of profit. This is made even harder by the time limits that some prop firms enforce, however most firms, like FTMO, are moving to no time limits models.

Drawdown to Profit Target ratios

FTMO true risk

The way that I represent this ‘true difficulty’ of a prop firm challenge is through the drawdown to profit target ratio. In the example of FTMO, the phase 1 drawdown to profit target ratio is 1:1, meaning for every $1 of maximum drawdown, $1 of profit target must be achieved.

ftmo drawdown to profit target ratio

Then, in phase 2, the lower 5% profit target means the drawdown to profit target is 1:0.5, meaning for every $1 of maximum drawdown $0.5 of profit target must be achieved.

If the maximum drawdown was the whole account, the drawdown to profit target ratios would be much lower, at 1:0.1 and 1:0.05. But the presence of the maximum drawdown restricts the risk that the trader can take, increasing the chances of failure and making the profit target harder to reach.

True Backing

Another impact of a prop firm’s maximum drawdown rule is true backing. True backing is the maximum amount of money that you can lose on a funded account before you lose the account, so it can be seen as the real amount you are funded with.

prop firm challenge true backing

For example, on a $100k funded account with 10% maximum drawdown, the true backing would be $10k. This reality about true backing, paired with the difficulty of passing the challenge is what allows prop firms to offer huge amounts of capital at a low price and still make huge profits.

As the first firm to popularise the online prop firm model, FTMO experienced huge growth and profits. But to understand why FTMO was having so much success, we have to discuss how prop firms like it actually make money.

How Prop Firms Make Money

how prop firms make money with challenges

Prop firms make money in two ways:

  1. Evaluation fees
  2. Copying funded traders’ trades

Prop firms make most of their revenue through evaluation fees. However, evaluation fees are refunded with the first payout, so the evaluation fee net revenue is only from failed challenges and failed funded accounts before the first pay-out.

This may give firms the incentive to make challenges harder to pass by adding hidden rules or unfavourable trading conditions, as a higher fail rate means less evaluation fee refunds and therefore higher net revenue. Behaviour like this is very short sighted as it will be called out by customers and hurt the reputation of the firm, reducing challenge purchases, and therefore reducing revenue in the long run. However, this doesn’t stop firms from participating in this unethical behaviour, but means it is usually carried out less obviously.

Prop firms also make money is by copying funded traders’ trades in the live markets. However, it isn’t as simple as them taking every trade that is executed by every funded trader. This isn’t feasible given the volume of trades taken on funded accounts. For prop firms to maximise profit and reduce the risk of ruin, most employ a hybrid a-book and b-book model.

A-Booking and B-Booking in Prop Firms

a book b book prop firms

In the context of prop firms:

  • A-booking a funded trader means the firm takes their trades
  • B-booking a funded trader means the firm does not take their trades

There are pros and cons to a-booking and b-booking, and a hybrid model means the prop firm has a risk team that weighs up these pros and cons for each funded trader then decides which booking method to use for them.

Quick note - Often larger prop firms use more complex methods than hybrid booking to extract profitable trading signals from their traders' data, but understanding simple A/B booking is an easier way to grasp how prop firms can use their traders' trades to make money.

A-booking

A-booking a trader is good when the funded trader is consistently profitable, because it means the prop firm makes money as the trader makes money. This means the firm pays the a-booked trader from actual profits made from the market, and the prop firm makes money from their share of the profit split.

The disadvantage is that if the a-booked trader loses money, the firm loses money too. While the a-booked trader loses money on the funded account, the firm takes 100% of the loss. But when the a-booked trader wins, the firm only gets 20% of the win because they pay the other 80% to the trader as a profit split. This means firms must be very confident that a trader is profitable before they a-book a trader, otherwise they are risking a lot for a low chance of a much smaller reward.

B-booking

While prop firm challenges are difficult to pass, they are not difficult or long enough to determine whether a trader is consistent or has just got lucky.

As a result, most prop firms b-book traders for the first few payouts. Payouts from b-booked traders are an expense for the firm and they are paid out from evaluation fee revenue and retained profits. But because most retail traders aren’t actually consistent traders, most who get funded never actually get a payout, and those who do only usually get one or two before blowing the account.

In fact, with My Forex Funds, only around 3.5% of traders who get funded earn a profit split. This means b-booking funded traders at the start is much cheaper than a-booking, as the expense of paying a few b-booked payouts is way less than the expense of backing most traders who blow the account before making any profit.

As successful funded traders earn more payouts the firms gain more data on their trading, which helps with the risk team with the decision of whether to a-book the trader. The more payouts a funded trader earns, the more likely they are a consistent trader and the less likely they have just got lucky, so it is safer for the prop firm to move the trader to a-book.

Multiplying A-booking

For extremely successful funded traders, prop firms capitalise on their success and start increasing their risk on the trader’s trades.

For example, the prop firm may start taking the trades with double the position size, meaning they make even more money as the trader profits. While the funded trader’s profit split is still based on the original position size, the prop firm gets to keep the extra profits generated by the larger positions taken. This does increase the prop firm’s risk if the funded trader starts to lose, but this method is only employed on traders that have consistently proven themselves, so they are likely to make up for their losses in the long run.

Alternative booking models

While the hybrid model is used by most prop firms, the specifics vary from firm to firm and some even use only a-booking or only b-booking models.

A-booking only

Firms that only a-book often advertise this as a selling point, and it can be a more stable model, but it requires certain rules to be sustainable for the firm.

These rules like relative drawdown protect the firm’s capital on funded accounts but are a disadvantage for traders as withdrawing all profits made after a certain point blows the account. So, if traders want to guarantee that their trades are being taken on the market this comes with a large cost. And at the end of the day, where funded trader’s profit splits come from doesn’t matter to most traders if everyone is getting paid out.

B-booking only

The problem arises when a firm uses an all b-booking model.

This means that the only source of revenue for the firm is evaluation fees, and therefore all payouts to funded traders come from evaluation fees. While this model may work for the firm in the short term when there aren’t many funded traders, it isn’t sustainable in the long term. When consistently profitable traders get funded with a b-book only prop firm, every payout that they earn costs the firm money. After a certain point, the firm won’t earn enough revenue from evaluation fees to pay their funded traders. This has happened before with the firm Funding Talent, which ended up closing down and not being able to pay its funded traders the profit splits that they had earned.

Requirements for the hybrid model to excel

As a result, the hybrid model of using a combination of both A and B-booking is the best model for both the firm and the trader, but it still relies on the challenge being difficult enough, so not too many traders pass, meaning the expense of b-booking traders isn’t too high. Also, a difficult challenge means firms can be more confident in funded trader’s abilities, so can start making money from them with a-book quicker.

The cost of improving prop firm challenges

prop firm challenges cost

The huge profits that FTMO made as the first popular online prop firm attracted new competition like My Forex Funds to the industry. These new prop firms offered easier challenges and higher profit splits to gain customers. But what are the consequences of these easier challenges?

  1. More traders pass the challenge and get funded
  2. More traders who take an evaluation reach a payout
  3. The quality of funded traders is lower as more bad traders can get lucky and pass

A challenge higher pass rate doesn’t instantly cost the firm, but it results in a higher percentage of traders who take the challenge reaching a funded account payout. This costs the prop firm in two ways.

Firstly, the expense of refunding the evaluation fee is increased as more people reach this point.

Then secondly the higher number of profit split payouts is an expense for the firm as most of the time newly funded traders are b-booked. This also presents the firm with the dilemma that while they want to reduce their expenses of b-booked payouts by moving traders to a-book, this decision is made much harder to do by the easier challenge. This is because the easier challenge allows more bad traders and gamblers to get funded. So, prop firms must wait longer before a-booking traders to avoid the huge expense of backing gamblers and bad trader’s trades. However, because of this extra caution needed before a-booking the firm will have increased expenses of b-booked profit split payouts.

As a result, as a prop firm challenges get easier, prop firm profits decrease.

prop firm challenge difficulty

Initially, this isn’t a problem, because prop firms have been such a profitable business model in the past that they can afford to sacrifice some of these profits to improve conditions for the traders. Prop firms will do this to increase market share of challenge purchases, so the extra evaluation fee revenue from higher purchases may initially make up for the higher expenses that come with the easier challenge.

However, as the whole industry reduces challenge difficulty there are only so many evaluation purchases to go around, which means firms that reduce challenge difficulty aren’t guaranteed increased sales as their competitors will just follow their changes to remain competitive. So, with every reduction in challenge difficulty, prop firm profits are slowly getting closer to zero.

This theory makes the prop firm industry seem more extreme than it is in reality: there are clearly still large profits being made by prop firms as there are so many new entrants to the market. Nevertheless, this heavy competition means these profits are being rapidly competed away. As prop firm challenges get easier the benefit to the trader increases, but only up to a certain point.

Once a prop firm challenge gets too easy, prop firm profits drop below the minimum required for the firm to function. As a result, the firm will close down, and won’t be able to pay profit splits to its funded traders, so the benefit to the trader drops to 0.

How Good is Too Good to be True?

If prop firm profits reduce as prop firm challenges get easier, there exists a challenge that is just hard enough for a prop firm to function, which would offer the very best experience for traders. Currently the easiest challenges offered are no time limit challenges with 10% maximum drawdown, 5% balance based daily drawdown and 8% & 5% profit target. Firms FundedNext offer challenges like this. As FundedNext is a large firm, them offering this challenge suggests that it is sustainable and profitable for the firm, as extensive risk modelling will have likely been carried out before they launched the challenge. But how far can these challenges be improved?

On Twitter, Matt L – the CEO of My Funded Fx said that a challenge with My Forex Funds’ competitive parameters of 12% max drawdown and 8% & 5% profit targets – but no time limits – wouldn’t be sustainable for the firm.

This suggests that the easiest possible challenge that is also sustainable for the firm lies somewhere in-between the current no time limits challenges offered and this unrealistic improvement to the My Forex Funds evaluation.

With so many new entrants to the prop firm industry, each firm is trying to offer improvements for the trader so they can stand out among other firms. But prop firms are a balance between the firm and the trader, if this balance is pushed to far nobody wins.