Accessibility in the forms of leverage accounts—global brokers within your reach—and the proliferation of trading systems have promoted forex trading from a niche trading audience to an accessible, global system.
However, the amount of capital traders have at their disposal will greatly affect their ability to make a living. A trader's ability to put more capital to work and replicate advantageous trades is what separates professional traders from novices. Just how much capital a trader needs, however, differs vastly.
- Traders often enter the market undercapitalized, which means they take on excessive risk to capitalize on returns or salvage losses.
- Leverage can provide a trader with a means to participate in an otherwise high capital requirement market.
- The leverage a trader requires varies, but if a trader is making consistent trades, the leverage required is simply enough that the trader is able to profit without taking unnecessary risks.
Considering Leverage in Forex Trading
Leverage offers a high level of both reward and risk. Unfortunately, the benefits of leverage are rarely seen. Leverage allows the trader to take on larger positions than they could with their own capital alone, but impose additional risk for traders that do not properly consider its role in the context of their overall trading strategy.
Best practices would indicate that traders should not risk more than 1% of their own money on a given trade. While leverage can magnify returns, it's prudent for less-experienced traders to adhere to the 1% rule. Leverage can be used recklessly by traders who are undercapitalized, and in no place is this more prevalent than the foreign exchange market, where traders can be leveraged by 50 to 400 times their invested capital.
A trader who deposits $1,000 can use $100,000 (with 100 to 1 leverage) in the market, which can greatly magnify returns and losses. This is considered acceptable as long as only 1% (or less) of the trader's capital is risked on each trade. This means that with an account size of $1,000, only $10 (1% of $1,000) should be risked on each trade.
While difficult in practice, traders should 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.
Respectable Performance for Forex Traders
Every trader dreams of becoming a millionaire by making intelligent bets off of a small amount of capital. The reality of forex trading is that it is unlikely to make millions in a short time frame from 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. When factoring fees, commissions, and/or spreads into return expectations, a trader must exhibit skill just to break even.
Simply being profitable is an admirable outcome when fees are taken into account. However, if an edge can be found, those fees can be covered and a profit will be realized. A trader that averages one tick per trade erases fees, covers slippage, and produces a profit that would beat most benchmarks.
Are You Undercapitalized for Making a Living in Forex Trading?
The high failure rate of making one tick on average shows that trading is quite difficult. Otherwise, a trader could simply increase their bets to five lots per trade and make 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.
In contrast, a larger account is not as significantly affected and has the advantage of taking larger positions to magnify the benefits of day trading. A small account by definition cannot make such big trades, and even taking on a larger position than the account can withstand is a risky proposition due to margin calls.
If the goal of day traders is to make a living off their activities, trading one contract 10 times per day while averaging a one-tick profit may provide an income, but is not a livable wage when factoring in other expenses.
The Bottom Line
There are no set rules on forex trading—each trader must look at their average profit per contract or trade to understand how many are needed to meet a given income expectation, and take a proportional amount of risk to curb significant losses.