Prop Trading Glossary: Understanding Drawdown, Split, and Challenge
Welcome back to fxbonus.insureroom.com, where we dig deeper into the secrets of the professional trading world.
The world of Proprietary Trading (Prop Trading) offers extraordinary opportunities to manage large capital without risking your personal money. However, once you step inside, you will be greeted by a flood of technical terms that are often confusing. These terms are not just cool jargon—they are the main pillars that determine whether you succeed or fail in the Prop Firm ecosystem.
As a meticulous researcher, I understand that the foundation of success starts with a solid understanding. If you plan to become a funded trader, mastering prop trading terms like Drawdown, Profit Split, and Challenge is mandatory. Ignorance of these terms could mean missed opportunities, or worse, losing your registration fee.
In this complete guide, we will dissect these three most crucial prop trading terms in clear and straightforward language. The goal is to empower you with the knowledge needed to navigate your Prop Trading journey with confidence.
1. Challenge (Evaluation): The Gateway to Big Capital
One of the first prop trading terms you will encounter when applying to a prop firm is Challenge or Evaluation.
Simply put, a Challenge is a test or series of tests designed by a prop trading company (Prop Firm) to assess your skills and discipline as a trader. It is the initial step you must pass to prove that you are worthy of being trusted to manage their real capital.
Prop Firms are not just looking for traders who can generate huge profits; they are looking for traders who are consistent and, most importantly, capable of managing risk. This exam ensures you have the right mental framework and strategy.
General Challenge Structure
Most Prop Firms use a two-phase evaluation model:
Phase 1: Ambitious Profit Target
The main goal in this phase is to reach a specific profit target (e.g., 8% or 10%) within a specified time frame, while adhering to all risk rules. This phase tests whether you have a profitable strategy.
Phase 2: Lighter Profit Target (Verification)
After successfully passing Phase 1, you will enter Phase 2. The profit target is usually lower (e.g., 4% or 5%). The purpose of Phase 2 is verification. The Prop Firm wants to see if your success in Phase 1 was a fluke or the result of a tested and consistent strategy.
Only after successfully completing both phases without violating risk rules will you be recognized as a Funded Trader and given access to a real account (or a simulated account replicating real trading, depending on the Prop Firm model).
Reasons Why the Challenge Is Important
The Challenge is not just a hurdle, but a filter. Prop Firms do not want to risk their capital on traders who lack discipline. If you often find it difficult in this phase, there might be something wrong with your risk management or psychology.
If you are curious, I have deeply analyzed the common factors that cause traders to fail in the evaluation phase. You can read about it in our article on [Reasons Why You Often Fail in Prop Firm Challenges].
2. Drawdown: Risk Limits You Must Understand
If the Challenge is the gateway, then Drawdown is the strict goalkeeper. Of all prop trading terms, this is the one that most frequently causes trader accounts to fail.
Drawdown is a term referring to the decline in equity value (account balance) from its peak (the highest value ever achieved). This is the main benchmark used by Prop Firms to limit the risk of loss you might cause.
There are two main types of drawdown you must understand.
A. Daily Drawdown (Daily Loss Limit)
Daily Drawdown is the maximum loss limit you are allowed to experience in a single trading day (usually calculated from the account balance or equity when the new trading day starts).
Example: If a Prop Firm sets a 5% Daily Drawdown on a $100,000 account, then you cannot lose more than $5,000 on that day. If at any point your loss (including floating loss) exceeds this limit, your account will be considered failed.
The purpose of Daily DD is to encourage discipline. If you experience a large loss, Daily DD forces you to stop, take a break, and not engage in revenge trading which often destroys accounts.
B. Maximum Drawdown (Max Loss Limit)
Maximum Drawdown is the total loss limit allowed for the entire Challenge period or the entire lifecycle of your Funded account. This is calculated from the initial account balance or, in many cases, from the highest equity value the account has ever reached.
Prop Firms usually distinguish Max Drawdown into two models that often confuse traders: Absolute Drawdown and Trailing Drawdown (Relative Drawdown).
Understanding Relative Drawdown (Trailing Drawdown)
Trailing Drawdown is the trickiest concept. This maximum loss limit moves along with the increase in your account equity.
- Account Start: The DD limit is placed on the initial balance (e.g., $100,000 - $5,000 = $95,000).
- Account Profit: If your equity rises to $103,000, your DD limit will also rise. The Prop Firm will maintain a certain distance (e.g., $5,000) from the highest equity value ever achieved. Your new limit becomes $98,000 ($103,000 - $5.000).
- Account Failure: If equity falls back, the DD limit will not go down. The account will fail if equity touches $98,000.
The Trailing Drawdown concept forces you to actively manage risk and lock in profits, because your failure threshold keeps increasing once you start generating profit.
Precision in calculating Trailing Drawdown is very important, especially when you become a Funded Trader. We have prepared a special guide to help you fully understand [What Is Relative vs Absolute Drawdown? Must Know!].
3. Profit Split: Reward for Your Hard Work
After you pass the Challenge and successfully become a Funded Trader, the next most pleasant prop trading term to discuss is Profit Split.
Profit Split is the profit-sharing agreement for earnings you generate from Prop Firm capital. This is your financial compensation for the professional trading services you have provided.
Common Profit Split Ratios
The most common Profit Split ratios offered by Prop Firms range from 70:30 to 90:10.
- 70:30: You get 70% of the profit, the Prop Firm gets 30%.
- 80:20: You get 80% of the profit, the Prop Firm gets 20%. This is the most common industry standard.
- 90:10: Some Prop Firms offer this ratio to attract top-tier traders, or after you reach certain scaling targets.
Why Do Prop Firms Take a Percentage?
You might ask, why should the Prop Firm take a share?
- Risk Coverage: Most of the Prop Firm's percentage is used to cover loss risks that might arise from their other traders' portfolios.
- Operational Costs: To cover platform, server, liquidity, technology costs, and support staff salaries.
- Company Profit: Of course, this is their business model. They make money from registration fees (Challenge Fees) and from the percentage of profits generated by successful traders.
Payout: Fund Disbursement Process
Profit Split is paid to you through a process called Payout.
Prop Firms have varying payout cycles. Initially, the first payout might have a longer waiting period (e.g., 14 or 30 days) to ensure that the profit you generate is stable. Afterward, many Prop Firms offer weekly or bi-weekly payouts.
Since profit split is the core of your reward, understanding the details is crucial. We have thoroughly peeled back this sharing system in our article: [Understanding the 80/20 and 90/10 Profit Split Concept].
Other Crucial Prop Trading Terms You Must Know
Besides the three pillars above, there are several other prop trading terms you will encounter:
4. Refundable Fee
Many Prop Firms require a fee to purchase a Challenge account. If you successfully pass the evaluation and get your first payout, this registration fee will often be fully refunded to you. This indicates that the initial fee is more of a deposit to ensure your seriousness.
5. Consistency Rule
Some Prop Firms apply this rule to prevent traders from relying on luck (gambling style). This rule ensures that your profits are spread evenly. For example, if you generate 50% of the target profit in just one big trade, and the rest are very small, you might violate the Consistency Rule. This forces you to use consistent risk management over time.
6. Scaling Plan
This is a reward for traders who perform well. A Scaling Plan is a promise that if you consistently generate profit (e.g., 10% every three months), the Prop Firm will increase the capital you manage (e.g., from $100,000 to $200,000). This is your career path to managing millions of dollars in capital.
Conclusion: Knowledge is Your Best Power
Prop Trading is a challenging and highly rewarding career, but only if you approach it with the right knowledge and realistic expectations.
Deep understanding of crucial prop trading terms—especially Drawdown, Challenge, and Profit Split—is key. You cannot rely on luck. You must be a meticulous researcher of the rules, just as you are meticulous in analyzing the market.
Remember, the Prop Firm is your business partner. They give you capital, and you give them disciplined and profitable trading skills. Focus on risk management, respect Drawdown limits, and make discipline your main strategy. With this equipment, you will be ready to face the Challenge and enjoy the Profit Split from your hard work.
Keep learning and keep growing. We at fxbonus.insureroom.com will always support your journey!
By: FXBonus Team
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