One of the unique advantages of the Forex market is that traders do not need huge amounts of capital. Unlike the stock markets, where traders need to put up huge amounts as collateral and also account for market valuations, the Forex market works differently.
Thanks to leverage and day trading, traders with just an average amount of capital to risk can start trading Forex efficiently. Of course, the success or failure from trading depends on a number of factors. Trading capital is just one of the many variables.
For the most part, in any form of speculation or investing, traders need to have adequate capital. Trading capital ensures that traders have enough capital to allocate for their open positions and also have enough capital in margin for the positions that they are in.
This begs the question as to how much capital is required to start trading. If someone tells you that you need a specific amount to trade Forex, then they are misleading you.
The amount of capital required to trade Forex depends on a lot of factors, such as the expected rate of return, your risk profile, and your trading strategy. Of course, you can trade Forex with 100,000 USD, and you can also trade Forex with just 1,000 USD. But what is the ideal amount to trade?
In this article, we will explore different ways to help you decide on the minimum capital that is required to start trading Forex. Note that this is highly subjective and can differ from one person to another. The answer also depends on a number of factors as touched upon earlier.
Most Forex brokers have a very low minimum requirement when it comes to opening a Forex trading account. On average, you can trade with just 100 USD in starting capital.
In some cases, Forex brokers also allow you to open a micro or a cent account which allows you trade with just 1 USD. However, expecting to grow such an account is impractical.
Risk management and Forex day trading requirements
When it comes to trading, the principles of risk management must be adhered to. This means that traders should follow the rule of thumb and stick to the one percent principle.
The one percent risk management principle states that traders should not risk more than one percent in their trading at any time. This one percent can be either allocated to one trade or to a series of trades. The bottom line being that no matter whether you have one or multiple positions, the risk should not be more than one percent of your account.
This makes an important point. For example, if your trading capital was just 100 USD, that means you should not risk more than 1 USD per trade. Is that possible? It is, when you trade micro lots. However, trading micro lots can be difficult to trade psychologically.
Trading with just 1 USD in risk can mean that at best you can make 2 USD if you follow the 1:2 risk reward setup religiously. However, that is not often the case. Traders can grow impatient and eventually make the mistake of risking more than the one percent that they were supposed to.
Thus, from this, we already know that trading with 100 USD and attempting to be successful will take a lot of work and patience, something which many beginners in trading lack and can lead to mistakes that could have been avoided in the first place.
So, does this mean that traders can trade with 1,000 USD? In this case, your risk once again is limited to 10 USD. While it is manageable, the amount of profits or returns you make is also the same. When you follow the 1:2 risk reward setup, it means that while you risk one percent, you aim to make two percent returns.
This looks good on paper, but if you crunch the numbers, you will see that in reality you are risking 10 USD and making a profit of 20 USD. For traders who dream about building a bankroll quickly, this can mean having to overcome some psychological barriers.
How much money do I need to start Forex trading?
There is no standard answer to this question. However, traders should focus on how much they expect to make in returns when risking their capital. A good way to start is to look at the risk-free rate of return.
The risk-free rate of return is the interest rate that is gained on an investment when there is no financial risk or loss involved during the period of time.
Typically bonds come into this picture, especially those that are risk free. Of course, the downside to risk free is that the rate of return is very small. In financial markets, the simple concept is that the more you risk, the more rewards you can get. However, traders should not blindly follow this principle but should apply some subjectivity to the matter.
In order to determine the amount of money needed to start trading Forex, the first step is to estimate the expected rate of return on your investment. An average number is around 2% - 5%, with the latter being an optimistic estimate on the returns.
Thus, from this starting point, you can then go into calculating the amount of money you want to invest. However, bear in mind that when you allocate your capital to Forex trading, it needs to be an amount that you can truly risk.
Many traders make the mistake of trading based on their credit card funds or other money, which eventually leads to large financial losses. Therefore, you should never trade with money that you cannot afford to lose. Risk is an important factor in financial market trading.
The next step is to understand the leverage that you want to use. Leverage can help you to magnify your positions. But if not used wisely, leverage can quickly lead to losses as well. Leverage and risk management go hand in hand and this is how you can determine your trading capital.
Focusing on the lot size can also help. Typically, the broker will give you the margin requirements when trading on leverage. Thus, you need to ensure that you have enough funds to account for the margin requirements and have additional funds in your account to account for the market valuation.
Say, for example, if your broker requires 1% of capital for the margin, then this means that you need to allocate not just 1% towards the capital requirements, but you should also have additional funds to cover the risks of the trade.
Capital scenarios for Forex day trading
Traders can also build up various scenarios based on the amount of capital they have. For example, you can follow this simple rule outlined in the table below.
Capital | Risk Amount | Pips | Leverage | Controlling size |
1,000 USD | 1% ($10) | 10 pips standard lot or 100 pips mini lot | 1:100 | 100,000 USD |
Based on the above, traders can now project the amount of trades they can make, while also accounting for the margin requirements for opening and maintaining a position.
The margin requirements are an essential aspect to help you understand the amount of capital needed to trade. Margin is essentially a good faith deposit. The margin is held in deposit by the broker when the trade is open.
A typical margin requirement could vary from one broker to another. For example, if a margin requirement is 2%, or 1:50 leverage, it means that traders should have 2% of their capital allocated in the margin account.
Thus, if you go back to the above table, a 2% margin requirement comes to 20 USD. This leaves you with 980 USD as free capital. Thus, when you bring in the 1% risk rule, you can risk just 9.8 USD and not the entire 10 USD as initially estimated.
Forex day trading - recommended capital
On average, the recommended capital can range from 500 USD to 1,000 USD. This is ideal, but requires a leverage of at least 1:100 if you want to trade actively and reap the rewards. However, choosing a high level of leverage can leave you exposed to the risks. These risks can be avoided as long as the trader is disciplined and patient.
Most traders tend to slip at some point in their trading and this leads to a major downward spiral. This can come by becoming over-leveraged or by ignoring the risk management rules.
Ideally, trading with the capital stated above with the recommended level of leverage can help traders to slowly build a profitable return on their capital. However, this requires the discipline to focus on just one or a few currency pairs.
Traders also need to ensure that they keep their positions clean and not open multiple positions on various instruments.
Conclusion
In conclusion, contrary to the popular advertising by Forex brokers; where you can trade with as little as $100, it is important to understand the risks of being undercapitalised.
Many traders focus on converting their $100 in capital into big profits, but this is not often the case. Being adequately capitalised is the basis from which everything else comes. This includes leverage that you are using and eventually comes down to the trading strategy and the stop loss levels that will determine the outcome of your trading success.
If given a choice, traders should focus on choosing enough capital so that they can choose their leverage wisely. This in turn will help traders to focus on their money management and trading strategy skills to build a consistently profitable business trading Forex.
