How much trading capital do forex traders need?

Accessibility in the forms of leverage accounts, global brokers within your reach and the proliferation of trading systems are all promoting forex trading for a wider audience. 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. In fact, the role of capital in trading is so important that even a slight edge can provide great returns, assuming that a more money means exploiting a position for larger monetary gains. A trader's ability to put more capital to work and replicate advantageous trades when conditions are right separates professional traders from novices.

So just how much capital is required to be a successful forex trader? We'll take a closer look at performance, fees and leverage to gain a greater perspective on your trading goals. (For further reading, see "Day Trading Strategies for Beginners.")

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 timefream 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. To put it into perspective, professional fund managers with millions of dollars at their disposal often make less than 10% to 15% per year, which means that the idea traders with small accounts could make double, triple or even 10 times their money in a single year is fairly misguided.

The reality is that when factoring fees, commissions and/or spreads into return expectations, 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, $1,050 will be spent on commissions alone, not to mention other fees such as internet, entitlements, charting or any other expenses a trader may incur in the course of trading. If the trader started with a $50,000 account based on this example, they would have lost 2% of that balance in commissions alone.

If we assume that at least half of the trades crossed the bid or offer and/or factoring slippage, 105 of the transactions will put the trader offside $12.50 immediately. That is an additional $1,312.50 cost for entering trades. By that calculation, our trader is now down $2,362.50 (close to 5% of their initial balance). This amount will have to be recouped through the profits on the investment before the trader can even start making money.

As we discussed in the above example, being profitable is an admirable outcome when fees are taken into account. However, if an edge can found, those fees can be covered and a profit will be realized. Let's assume that a trader can establish a one-tick edge, meaning that on average they make only a one-tick profit per round trip. Under those conditions, that trader will make:

210 trades x $12.50 = $2,625

Now we'll subtract the $5 commissions the trader comes out ahead by:

$2625 - $1050 = $1,575, or a 3% return on the account per month

This calculation shows that while the trader has winning and losing trades, when the trades are averaged out, the resulting profit is one tick or higher. A trader that averages one tick per trade erases fees, covers slippage and produces a profit that would beat most benchmarks. (To learn more, see "Price Shading in the Forex Markets.)

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 (which as we saw is a very high rate of return) may provide an income, but is not a livable wage when factoring other expenses.

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. (For more insight, see "Understanding Forex Risk Management.")

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 (For further reading on leverage, see "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, 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. In the volatile forex market, most traders will be continually stopped out with an amount this size. Therefore, traders can trade micro lots, which will allow them more flexibility even with only a $10 stop. The allure of these products is to increase the stop, yet this will likely result in lackluster returns, as any trading system can go through a series of consecutive losing trades.

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.

For example, with an average five-pip profit and 10 trades per day with a micro lot of $1,000, the trader will make $5 (Note: this is an estimate and will depend on the currency pair traded). This does not seem significant in monetary terms, but a 0.5% return on a $1,000 account in a single day is notable.

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 translate to substantial returns. Traders often enter the market undercapitalized, which means they take on excessive risk by not adhering to the 1% rule outlined above. Leverage can provide a trader with a means to participate in a otherwise high capital requirement market, yet the 1% rule should still be used in relation to the trader's personal capital.

This is where having an edge comes into play. Even though combining an edge with sound trading principles means that profits will come as the account grows, the account must be large enough to provide enough monetary returns to support a livable wage. 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 Exchange walkthrough.