Access to leverage accounts, easy access to global brokers and the proliferation of trading systems promising riches are all promoting forex trading for the masses. However, it is important to keep in mind that the amount of capital traders have at their disposal will greatly affect their ability to make a living from trading. In fact, capital's role in trading is so important that even a slight edge can provide great returns. This is because an edge can be exploited for large monetary gains only through large enough positions and replication (or frequency). A trader's ability to implement size and replication when conditions are right is what separates a true professional from less-skilled traders. This is accomplished by - among many other things - not being undercapitalized.
So just how much capital is required? Find out how much income you need to meet your trading goals - and whether ultimately, your goals are realistic. (For more, check out Day Trading Strategies For Beginners.)
What Is Respectable Performance?
Every trader dreams of taking a small amount of capital and becoming a millionaire off of it. The reality is that it is unlikely to occur by trading a small account. While profits can accumulate and compound over time, traders with small accounts often feel pressured to use large amounts of leverage or take on excessive risk in order to build up their accounts quickly. Not realizing that professional fund managers often make less than 10-15% per year, traders with small accounts often assume they can make double, triple or even 10 times their money in a single year.
The reality is, when fees, commissions and/or spreads are factored in, a trader must exhibit skill just to break even. Take for example an S&P E-mini contract. Let's assume fees of $5 per round trip trading one contract and that a trader makes 10 round trip trades per day. In a month with 21 trading days this trader will have spent $1,050 on commissions alone, not to mention other fees such as internet, entitlements, charting or any other fees a trader may incur in the course of trading. If the trader started with a $50,000 account, in this example, he would have lost 2% of that balance in commissions alone.
If we assume that at least half the trades crossed the bid or offer and/or factoring slippage, 105 of the trades will put the trader offside $12.50 immediately. That is an additional $1,312.50 cost for entering trades. Thus, our trader is now in the hole $2,362.50 (close to 5% of his initial balance). This amount will have to be recouped through the profits on the investment before the investor can even start making money!
A Realistic Look at Fees
When fees are looked at in this way, just being profitable is admirable. But if an edge can found, those fees can be covered and a profit realized. Assuming that a trader can establish a one-tick edge, meaning on average they make only a one-tick profit per round trip, that trader will make:
210 trades x $12.50 = $2,625
Minus the $5 commissions the trader comes out ahead by:
$2625 - 1050 = $1,575, or a 3% return on the account per month
The average profit shows that while the trader has winning and losing trades, when the trades are averaged out the resulting profit is one tick or higher.
Making an average of one tick per trade erases fees, covers slippage and produces a profit that would beat most benchmarks. Despite this, a one tick average profit is often scoffed at by novice traders who shoot for the stars and end up with nothing. (To learn more, see Price Shading In The Forex Markets.)
Are You Undercapitalized for Making a Living?
Making only one tick on average seems easy, but the high failure rate among traders shows that it is not. Otherwise, a trader could simply increase the trade size to five lots per trade and be making 15% per month on a $50,000 account. Unfortunately, a small account is significantly impacted by the commissions and potential costs mentioned in the section above. A larger account is not as significantly affected. The larger account also has the advantage of taking larger positions to magnify the benefits of day trading. A small account cannot make such big trades, and even taking on a larger position than the account can withstand is very risky because this could lead to margin calls.
Because one of the common goals among day traders is to make a living off their activities, trading one contract 10 times per day while averaging a one-tick profit (which as we saw is a very high rate of return) may provide an income but factoring other expenses, it is unlikely that income will be one on which a trader could survive.
An account that is able to trade five contracts can essentially make five times as much as the trader trading one contract, as long as a disproportionate amount of capital is not risked.
There are no set rules on how many trades to make or contracts to trade. Each trader must look at his or her average profit per contract/trade to understand how many trades or contracts are needed to meet a given income expectation. How much risk a trader exposes himself to in doing this is also of prime concern. (For more insight, read Understanding Forex Risk Management.)
Leverage offers high reward coupled with high risk. Unfortunately, since many traders do not manage their accounts correctly, the benefits of leverage are rarely seen. Leverage allows the trader to take on larger positions than they could with their own capital alone.
Since traders should not risk more than 1% of their own money on a given trade, leverage can magnify returns, as long as the 1% rule is adhered to. However, leverage is often used recklessly by traders who are undercapitalized to begin with. In no place is this more prevalent than in the foreign exchange market, where traders can be leveraged by 50 to 400 times their invested capital. (Learn more about this in Forex Leverage: A Double-Edged Sword and Adding Leverage To Your Forex Trading.)
A trader who deposits $1,000 can use $100,000 (with 100 to 1 leverage) in the market. This can greatly magnify returns and losses. This is fine as long as only 1% (or less) of the trader's capital is risked on each trade. This means with an account this size only $10 (1% of $1,000) should be risked on each trade. In the volatile forex market, most traders will be continually stopped out with a stop so small. Therefore, in this market traders can trade micro lots, which will allow them more flexibility even with only a $10 stop. The lure of these products is to increase the stop, yet this will likely result in lackluster results as any trading system can go through a series of consecutive losing trades.
In this example, traders need to avoid the temptation of trying to turn their $1,000 into $2,000 quickly. It may happen, but in the long run the trader is better off building the account slowly by properly managing risk.
With an average five-pip profit and making 10 trades per day with a micro lot ($1,000), the trader will make $5 (estimated, and will depend on currency pair traded). This does not seem significant in monetary terms, but it is a 0.5% return on the $1,000 account in a single day. As the account grows the trader may be able to make a living off the account, but attempting to make a living off a small account will likely result in increased risks, excessive use of leverage and often large losses. (For more, see Forex Leverage: A Double-Edged Sword.)
Traders often fail to realize that even a slight edge such as averaging a one-tick profit in the futures market, or a small average pip profit in the forex market can mean substantial percentage returns. Most traders enter the market undercapitalized, which means they take on excessive risk by not adhering to the 1% rule. Leverage can provide a trader with a way to participate in a otherwise high capital requirement market, yet the 1% rule must still be used in relation to the trader's personal capital. Profits will come as the account grows, and making a living only requires a small edge, but the account must be large enough to provide monetary returns the trader can live off of. The edge is exploited by repeatedly putting enough capital into play (without excessive risk) to turn the edge into a livable income. (For a step-by-step look at how to get started in forex, check out our Forex Walkthrough.)
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