Leverage and the Economics of Funded Trading Accounts

One of the key tenets of finance and economics is the risk-return trade-off, which states that the greater the potential return, the greater the risk. This concept explains the rapidly growing popularity of proprietary trading firms and funded trading accounts. Prop firms use pooled investments from multiple traders who would have access to much less capital if trading individually, allowing these traders to use leverage to seek more significant profits. Large amounts of capital incentivize the trader but also lead to increased volatility, heightened downside risk, and increased importance of risk management.

The demand for funded trading accounts is primarily based on capital limitations, not a trader's skill or ability. Retail traders may be highly skilled, disciplined, or have profitable trading strategies, yet they do not have enough personal capital to generate the income from their trading from their own funds. For example, if a trader has a personal account with $2000 and earns a 5% return in a month, they will have made only $100 before paying any fees or taxes. However, if the trader has access to a $100,000 funded account, the potential income from this account will be too great.

This creates an enormous demand for companies that offer access to capital in exchange for a share of the profits earned by the trader. Companies that operate within the proprietary trading sector, like OneFunded, utilize trading challenges and evaluation systems as a means to identify prospective traders who can meet the defined risk limits established by the firm. Evaluation systems will typically include defined drawdown limits, profit targets, and a consistency requirement, and are used in an attempt to limit the firm's exposure to excessive risk.

Leverage allows a trader to control a trade, much larger than the trading account they placed as a deposit. Trading with leverage gives a trader more of a chance to achieve a higher return on a successful trade, but also gives the trader higher potential losses, as both sides of the leverage increase. For example, a one percent movement in the market price of a stock would create a small profit/loss for a trader trading without leverage. However, if there is leverage involved in the trade, there would be a much greater profit or loss.

This is an example of the risk-return relationship that exists within Weighted Average Cost of Capital (WACC). Larger accounts will provide a trader with a higher expected return than without leverage. The larger companies will provide a higher expected return, which will also have a higher maximum level of exposure to volatilities and downside risk. As a result, the investors expect to be compensated for the risk they are taking on with the uncertainty of higher returns being a way to compensate for a higher level of risk. Prop trading firms attempt to balance both conflicts with the use of properly implemented, defined and structured risk management.

An example of how this works can be found in many funded accounts. A trader will generally lose 5 to 10 percent before their funded account will no longer be funded. These maximum limits are important from an economic perspective because they will prevent the funded trading firm from losing a large portion of their capital and encourage the trader to have a disciplined, systematic approach to trading. Therefore it aligns the interests of the trader with the capital provider.

Finally, another major factor driving growth in this industry is the ease of access to digital trading platforms. Digital trading system improvements, improved real-time data feeds and the education available online have lowered the barrier to entry for retail traders to the financial markets. There are now millions of people worldwide actively trading in currencies, commodities, indices and other instruments from home; however, even though the number of people able to participate in the financial markets has increased substantially, most traders still do not have a lot of capital to invest in trading. Funded trading companies will play a critical role in providing capital to individual traders.

Real market information shows the extent of leveraged trades on global financial markets. In the foreign exchange market alone, daily global trading volume exceeds $7 trillion, according to the Bank for International Settlements. A large proportion of daily trading volume consists of highly leveraged speculative or short-term trading strategies, creating substantial risk for traders because these positions can generate large profits during favorable market conditions while also producing significant losses during periods of volatility.

There are many ramifications of funded or "capitalized" trading structures. On one hand, they create access to larger pools of capital, allowing skilled traders to trade professional-sized positions without risking their life savings. Thus, these models may increase the number of people able to participate in trading and create a broader pool of qualified individuals who otherwise may have been excluded from professional financial markets.

On the other hand, the incentives associated with funded trading accounts may encourage increased risk-taking among some traders. The fact that many funded traders are evaluated primarily on performance over relatively short time frames may provide an incentive to adopt aggressive trading strategies in order to achieve profitability targets. As a result, there is always a careful balancing act between risk and opportunity within leveraged trading environments.

The rise of funded trading accounts reflects changing financial culture, as well as advances in trading technology. Increasingly, trading is viewed as a form of entrepreneurial participation in the broader global economy rather than solely as an investment activity. Firms that provide trading capital increasingly monetize their risk-management systems and trading infrastructure while delegating trade execution to individual traders operating independently.

As long as capital markets continue to create opportunities for leverage, capitalized trading structures will likely remain closely tied to the longstanding relationship between risk and reward.