To receive new articles instantly Subscribe to updates.
Forex trading capital confusion
Written by: PaxForex analytics dept - Tuesday, 02 June 2015 0 comments
A lot of forex traders enter the market without having a clear vision of how much trading capital is actually required. Many forex brokers have either no minimum deposit or a very small often, often less than $100. When you add leverage of 1:500 to that you $100 deposit can control $50,000. While the combination of a low deposits and high leverage does attract many to the forex market there are a few misconceptions on this topic.
One of the biggest mistakes is that new forex traders apply the wrong math to the potential returns of their trading account. For example they calculate that they can achieve 5% returns per month, which if performed on a consistent base is very high and not achievable by the best forex traders out there. For this post we will use the 5% mark, but keep in mind that an average return of 20% per year would be a fantastic trading outcome.
A new trader often makes the following mistake: The compute that 5% of $100 is $5 per month, the math is correct. Then they simply multiply this by the leverage, in our case 1:500, which leaves them with 5% of $50,000 which translates to $2,500
in profits; again the math is right. So in this case, their $100 all of the sudden, instead of returning 5%, has resulted in a profit of 2,500%. You can see how unrealistic this type of outcome is.
Since the math is correct, why is the above example unrealistic? The answer is very simple: You will never trade 100% of your portfolio in in one single trade. Should you decide to open such a position you will quickly see your account zap down to zero as soon as your currency pair moves one pip which can happen in the blink of an eye. Once you start trading with proper risk management, for example not risking more than 2% of your capital, you will see a much more realistic outcome.
The wisest thing to do is to calculate your potential profits and apply your risk management to the amount you have deposited and not multiplying it by leverage. So if you have $100 and you can make 5% per month than you would earn $5 per month. For an even more realistic outcome you may want to select 12% per year which will leave you with $12 in net profits from a $100 trading account after one year; again if you applied proper risk management and have the right trading strategy.