Proprietary trading, often referred to as prop trading, is a practice where a financial institution or a trading firm uses its own capital to engage in various financial markets, including stocks, bonds, commodities, currencies, and derivatives. In contrast to conventional trading methods where firms execute trades on behalf of their clients, prop trading involves utilizing the firm’s own money with the main goal of generating profits.
A large number of forex prop trading firms train and offer career opportunities to students, retail traders, and individuals interested in trading. And in most cases, these firms provide advanced tools necessary to be successful in the markets.
Compensation structure in prop trading varies from company to company. However, in the majority of cases, firms use performance-based compensation methods. Which has its own challenges and benefits.
The Importance of Performance-Based Compensation
The performance based compensation system is important in prop trading for various reasons. Some of the most notable ones are:
- Alignment of Interests: when traders directly benefit from their successful performance, they are more motivated to work harder and earn money.
- Efficiency and Productivity: Performance-based compensation is highly cost effective for the company, as there are no extra charges. Traders earn a percentage from the money they bring to the company.
- Meritocracy: Performance-based compensation system builds meritocratic environments where success is directly linked to talent and performance. In such systems successful traders are recognised and elevated in the competence dominance hierarchy, which further increases their motivation to work hard.
- Adaptability to Market Conditions: market conditions can often change, profitable traders might become unprofitable and vice versa. The performance-based compensation system eliminates the risks of funding unproductive traders. In addition, there is no need for the prop firm managers to constantly review and assess how much to spend on their traders. The process is much simpler and smoother.
Risks and Challenges
While it’s true that performance based compensation structure is a strong motivator for traders to work harder and generate more income, it comes with its disadvantages. Among major ones are:
- Income Volatility: income generated from trading is never steady. No matter how good trading strategies are, every strategy experiences drawdown periods. They might be months when instead of making money, the account balance loses capital. The key to success is to have enough trades that cover for the losses. The income volatility can be stressful for the traders.
- Risk-Taking Behavior: When income depends on performance, traders are more motivated to take higher risks, which is always a bad idea. As mentioned earlier, there will be months when trading strategies stop working, and doubling down on risks will only increase the losses. The proper strategy to handle drawdowns is to change to demo trading or reduce market exposure and wait for the market conditions to return to optimal.
- Short-Term Focus: traders that earn money based on performance care about what happens this month/next month, and don’t plan long term. Which can be damaging for the company.
- Pressure and Stress: traders are under more pressure to perform when they are not paid with steady salaries. Getting a bank loan can be difficult, and ignoring human emotions can be difficult when placing orders.
- Talent Retention Challenges: due to the instability of the payouts, many traders will simply find it hard to remain in the company long term. It’s difficult to plan your future when you are not sure whether you’ll take a salary next month or not.
- Overemphasis on Individual Performance: one of the main benefits of working in a prop firm is that traders have the chance of working as a team. When the compensation structure depends on performance, collaboration and teamwork gets undermined.
Regular salary + Bonus based compensation system
There are prop trading firms that offer stable salaries and bonuses for traders’ individual performance. In addition, there can be collective bonuses at the end of each year. For instance, if a company grew its capital within a year, a certain percentage of the growth can be equally divided between the employees. The bonus based compensation system creates a more stable environment for traders, on the other hand, desire to earn more gets decreased, which may not be a bad thing, as risk appetite also decreases. Most investors are looking for steady growth with low risks. And when risks are managed well, more money can be made simply by attracting more investors.
Most of the risks and challenges related to performance based compensation gets eliminated when traders get steady paychecks with bonuses on top. However, the lack of motivation can make traders lazier, and the firm might need more effort to motivate traders.
As an alternative, prop firms can offer traders a small salary to make sure they don’t starve when the strategies are in drawdown phase, and high bonuses.
To sum it all up, performance-based compensation systems in prop trading come with its own challenges and benefits. The most notable benefits are: alignment of traders’ interests with the company’s interests, improved efficiency and productivity, meritocracy, and adaptability to market conditions. The main risks include: income volatility for traders, increased interest in risk-taking, short term focus, pressure and stress, talent retention challenges, and damaging collaboration and teamwork. In addition to salary based and performance based-compensation systems, Prop firms can use bonus based compensation systems to get the best of both worlds.