How much capital is needed for forex trading ?
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 size of each trade and be making 10% per month on a $10,000 account. Unfortunately, a small account is significantly impacted by the commissions and other costs involved when trading. A larger account instead is not as significantly affected because it has the advantage of taking larger positions to magnify the benefits of day trading. A small account cannot make big trades as this would put at risk the trading capital itself and 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 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 needs to look at his average profit per 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.
Leverage and the 1% rule in forex trading
Leverage offers high reward but at the same time it is coupled with high risk. Unfortunately, since many traders do not manage their accounts correctly, the benefits of leverage are rarely seen. The great thing about leverage is that it allows traders 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.
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% 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. This is a simple rule if one want to survive and make money out forex trading. That's it. Anyone who tries to break this rule puts his/her money at unnecessary risk.
With this in mind, traders need to avoid the temptation of trying to turn their $1,000 into $2,000 quickly. It can certainly 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.
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 so to be able to turn the edge into a livable income.
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