How Much Capital Should I Trade Forex With?

By Jeremy Wagner, Lead Trading Instructor  and  Timothy Shea,

Summary:Research shows that the amount of capital in your trading account can affect your profitability. Traders with at least $5,000 of capital tend to utilize more conservative amounts of leverage. Traders should look to use an effective leverage of 10-to1 or less.

In looking at the trading records of tens of thousands of FXCM clients, as well as talking with even more traders daily via live webinars, Twitter, and email, it appears that traders enter the Forex market with a desire to cap their potential for losses on their risk based capital. Therefore, many newer traders choose to start trading forex with a small capital base.

What we have found out through the analysis of thousands of trading accounts is that traders with larger account balances tend to be profitable on a higher percentage of trades. We feel this is a result of the EFFECTIVE LEVERAGEused in the trading account.

Figure 1

Since many smaller traders are inexperienced in trading forex, they tend to expose their account to significantly higher levels of effective leverage. As a result, this increase in leverage can magnify losses in their trading account. Emotionally spent, traders then either give up on forex or choose to compound the issue by continuing to trade in relatively high amounts of effective leverage. This becomes a vicious cycle that damages the enthusiasm which attracted the trader to forex.

No matter how good or bad your strategy is, your decision (or non-decision, as the case may be) about effective leverage has direct and powerful effects on the outcomes of your trading. Last year, we published some tests showing the results over time of the same strategy with different leverage. You can read it in the article Forex Trading: Controlling Leverage and Margin.

Figure 2

In figure 2, we have modified 2 elements of the chart in figure 1. First, we renamed each column to represent the highest dollar value that qualified for the given column. For example, the $0-$999 equity range is now being represented as the $999 group. The $1,000 - $4,999 equity range is now being represented as the $4,999 group. And likewise, the $5,000 - $9,999 range is now being represented as the $9,999 group.

The second change made was that we calculated the average trade size of each group and divided it into the maximum possible account balance for that group. In essence, this provided us a conservative and understated effective leverage amount. (A larger balance reduces the effective leverage so the red line on the chart is the lowest and most conservative calculation of the chart.) For example, the average trade size for the $999 group was 26k. If we take the average trade size and divide it by the account equity, the result is the effective leverage used by that group on average.

As the effective leverage dropped significantly from the $999 group to the $4,999 group (red line), the resulting proportion of profitable accounts increased dramatically by 12 basis points (blue bars). Then, as further capital is added to the accounts such that they moved into the $9,999 category, the effective leverage continued to incrementally drop pushing the profitability ratio even higher to 37%.

Game Plan: How much effective leverage should I use?

We recommend trading with effective leverage of 10 to 1 or less. We don’t know when the market conditions will change causing our strategy to take on losses. Therefore, keep the effective leverage at conservative levels while using a stop loss on all trades. Here is a simple calculation to help you determine a target trade size based on your account equity.

Account Equity X Effective Leverage Target = Maximum Trade Size of All Combined Positions

10 : 1 Leverage Calculations
Account Equity Trade Size $5,000 50,000 $10,000 100,000 $25,000 250,000 $100,000 1,000,000 $1,000,000 10,000,000
Figure 3

The above illustration shows a trader’s account size and the maximum trade size based on 10 to 1 leverage. That means if you have $10,000 in your account, then never have more than 100,000 of open trades at any one time.

The precise amount of leverage used is decided entirely by each individual trader. You may decide that you are more comfortable using an even lower effective leverage such as 5 to 1 or 3 to 1.

Most professional traders enter into trading opportunities focused on how much capital they stand to lose rather than how much capital they are looking to gain. Nobody knows the future movement of prices so professional traders are confident in their trading approach but conservative in their use of effective leverage.

Adjusting the effective leverage to suit your risk tolerance

Our research indicates that accounts with the smallest capital base (the group labeled $999) have an average trade size of 26k for each trade. Their effective leverage is at least 26 times which is significantly higher than the 10 times leverage discussed earlier. If these traders want to trade at no more than a 10 to 1 effective leverage, they would need to make at least one of the adjustments noted below:

Increase their trading account equity by depositing more funds to an amount that reduces their effective leverage to less than 10 to 1. So our average trader, who is averaging 26k trade sizes, would need at least $2,600 in their account to trade 26k on a 10 to 1 effective leverage.

Decrease their trade size to a level that reduces their effective leverage to less than 10 to 1. Use the figure 3 calculations and chart above.

Figure 4

In the chart above, notice how the trade size remains relatively stable as the account equity increases from the $999 group to the $4,999 group. In essence, this indicates that traders are looking for, on average, at least $2.60 per pip (if they average 26k trade size, that is approximately $2.60 p/l per pip in most currency pairs).

There could be many reasons why traders average at least 26k for each trade, or $2.60 per pip. Perhaps they want a large enough trade size to make their time invested trading worthwhile. In other words, traders may be seeking a price per pip value and $2.60 is the minimum threshold on average. If these traders were to use no more than 10 to 1 effective leverage, they would need at least $2,600 in their account to support $2.60 per pip.

Another possibility is that many newer traders simply don’t understand the power of leverage and how one large losing trade can wipe out several winning trades in a row. Using a conservative amount of leverage will help slow down the rate of capital losses when a trader goes through a losing streak.

Regardless of the reasons, our goal is to use conservative amounts of leverage. If you know how much risk capital you have available, then use the chart and calculations used in Figure 3 to determine an trade size appropriate to your account size.

If you have a target “per pip” value, then use the calculations in figure 5 to determine the minimum amount of account capital needed to support your trade size. Increasing your capital base does not mean you will become more profitable. It means that you can stay in a trade longer if it goes against you. On average, traders that use a combination of sufficient capital (at least $5,000) and conservative use of effective leverage (10 to 1 or less) tend to be more profitable.

DailyFX Resources for Successful Money Management

The DailyFX Course Instructors have years of experience trading the markets and helping thousands of new traders learn forex.

Introduction to Money Management Video

Controlling Leverage and Usable Margin - presentation from 2011 FXCM Expo

Arriving at a Risk/Reward Ratio

Would You Like to Increase Your Chances of Becoming a Successful Trader?

FXCM Clients can take free interactive classes via the DailyFX PLUS Trading Course.

The Traits of Successful Traders

This article is a part four of our four-part Traits of Successful Traders series.

Part One: What is the Number One Mistake Forex Traders Make?

Part Two: When is the Best Time of Day to Trade Forex?

Part Three: Here is How to Trade Forex Majors Like the Euro during Active Market Hours

Over the past several months, The DailyFX Research team has been closely studying the trading trends of FXCM clients, utilizing the enormous amount of trade data at FXCM. We have gone through an enormous number of statistics and anonymized trading records in order to answer one question: “What separates successful traders from unsuccessful traders?”. We have been using this unique resource to distill some of the “best practices” that successful traders follow, such as the best time of day, appropriate use of leverage, the best currency pairs, and more. You can learn more about the project and see further research at DailyFX.com.

Here is How to Trade Forex Majors like the Euro During Active Hours

By David Rodriguez, Quantitative Strategist  and  Timothy Shea,

Summary: North American trading hours tend to be the most difficult to trade in due to the high level of volatility in the market. Breakout trading strategies tend to do relatively well in volatile environments, so if you plan to trade during these times, look to trade breakouts.

Watch a video of David Rodriguez presenting this research at the 2011 FXCM Currency Trading Expo atfxcmexpo.com.

Our past research shows that traders could be well-served restricting their trading to less-active trading hours, as general trader profitability tends to improve when markets are less volatile. But what if you can’t trade when it’s quiet? For traders who feel the need to be in the market during the more volatile times, here is some advice about how to do it.

The chart above emphasizes that FXCM clients tend to do poorly in the 5 most popularly traded pairs during the North American daytime. If we compare these results with measures of volatility, we can see that this poor performance seems directly correlated to sharp price swings, as this time of day tends to be the most volatile. The chart below shows the average hourly moves in pips for the EUR/USD, the most popular currency pair to trade. You can see that traders’ best results coincide with the times of day that have lower volatility, such as the Asia trading session.

Our previous article showed that the highly popular Relative Strength Index trading strategy produced significantly better risk-adjusted returns if we limited it to trade exclusively during the least-volatile hours of the trading day, 2 PM to 6 AM Eastern Time (New York).

What Strategy Should I Use to Trade the US Daytime?

As mentioned before, we advise traders to trade during the lower-volatility times of day due to the risks that volatility present, and the better results we see in the range trading strategies that FXCM clients tend to use. Some traders may prefer to trade during the volatile US daytime, however. So, if you’re going to do that, make sure that you use the appropriate strategy at the appropriate time. Do not try to range trade. Instead, do the opposite: trade breakouts.

What is a Breakout?

A breakout is when a currency that has been trapped in a range or channel on the chart breaks through support or resistance, escaping the channel. When this happens, the movement in prices tends to be very powerful, and can create a trading opportunity.

Here is an example where the EUR/USD Daily chart had a channel for two months. You can see that when this channel broke, the move was swift and powerful.

How Do You Trade Breakouts?

Trading breakouts is almost the exact opposite of trading ranges. When price moves upwards through resistance, look to buy. When it moves downard through support, look to sell. In the above example, a range trader would have tried to sell at the top of the channel and would have likely lost money. A breakout trader would instead have looked to buy.

Sample Strategy: Channel Breakout

The Channel Breakout strategy is quite straightforward and has performed fairly well historically. the system draws a channel surrounding price action, with the top of the channel set at the highest high and the bottom set at the lowest low of the past twenty bars. In the chart below, you can see the top of the channel in light blue and the bottom of the channel in red. The green dotted line shows profitable trades made by the system, while the red dotted line shows losing trades made by the system.

We sell the currency pair if the price breaks below the channel bottom. If price quickly reverses, we will be taken out of the trade at a loss. Yet if price continues lower, we stand to see profits on the continued moves.

Thus we can conceptualize this this trade system might work especially well during times of high volatility, when channels tend to be broken. Let’s test by looking at how well it has done on the Euro/US Dollar in the past several years:

Channel Breakout Strategy on EURUSD Pair from 2001-2011, 60min Chart

The channel breakout system did reasonably well overall, and especially well during times of strong market volatility in late 2009. Yet it has also had long stretches of underperformance and noteworthy losing streaks. Since we know that breakout strategies tend to work better during times of higher volatility, how can we instruct our system to trade only during those times?

When Should I Look to Trade Breakouts?

Every day, we publish Volatility Percentile figures on the DailyFX Technical Analysis page for reference. The Volatility Percentile is derived from FX options prices. The higher the number, the more volatile options traders expect the currency pair to be. We can use these volatility percentages to judge when it is best to use particular strategies. When volatility percentages are high, we look to trade breakout strategies. When they are low, we look to avoid them.

When looking at the Channel Breakout strategy above, a quick optimization shows that the strategy improves noticeably when we apply filters. We simulate two cases below. In one case, the strategy is only allowed to trade when our Volatility Percentile is above 50%. In the other, it is only allowed to trade when it is above 75%. As you can see in the chart below, in both cases we see better overall results than the “base case” of letting the system trade at any time.

With the 50 percentile filter, the strategy is allowed to trade about half the time. With the 75 percentile filter, the system can only trade about 25% of the time. Over time, the 50 percentile filter has been shown to prevent many of the losing trades in the system, while preventing only a few of the winning trades. This has produced the best historical returns on an overall final net-profit basis but has also shown significant losing streaks.

With the 75 percentile filter, prevents even more trades – both good ones and bad ones. While the overall result over the past six years has not been quite as good as the 50 percentile one, there were few times of significant losses. Indeed, when we fully take risk into consideration, we prefer the 75th percentile filter, as it makes rather fewer losing trades and we are glad to forego some potential profits in order to lower our risk of potential loss.

Game Plan: What Strategy Should I Use?

When volatility is above 75%, trade using a breakout strategy.

Our data show that over the past 10 years many individual currency traders have generally been unsuccessful trading in times of high volatility. As we spoke about in our earlier article, we generally recommend trading European currencies during the “Off Hours” using a range trading strategy, as this approach tends to produce good results and best matches how most FXCM clients trade.

Traders who feel the need to trade during times of high volatility should use a different strategy and look to trade breakouts rather than ranges. Breakout trading tends to show the best risk-adjusted returns if limited to the most volatile trading days. We can use the DailyFX Volatility Percentageto easily gauge what FX options traders expect for volatility in the near future. When above 75%, breakouts are significantly more likely than normal, so look for opportunities.

DailyFX Resources for Successful Breakout Trading

The DailyFX Trading Instructors have years of experience trading the markets and helping thousands of new traders learn forex. Here are a few of their many tips that can help you breakout trade better:

Trading the Majors without Getting Burnt (Video)

How to Trade a Breakout Strategy on the EUR/USD

Exclusive for FXCM Clients: Sign Up for Live Classes

FXCM Clients can take free interactive classes via the DailyFX PLUS Trading Course.

Model Strategy: Channel Breakout Trading on a 60 Minute Chart

For our models, we used one of the most common and simple breakout trading strategies there is, creating channels on a 60 minute chart.

Entry Rule:When price crosses above the highest price of the last 20 bars, buy at market on the open of the next bar. When price crosses below the lowest price of the last 20 bars, sell at market on the open of the next bar.

Filter: Strategy can only enter new trades when the Volatility Percentage is above the specified level (such as the 50% or 75% examples used above).

Exit Rule: Strategy will exit a trade and flip direction when the opposite signal is triggered.

As was shown earlier, in the EUR/USD this strategy has shown the best risk-adjusted returns in the EUR/USD over the past 6 years when it was restricted to trade only when the Volatility Percentage was above 75%.

The Traits of Successful Traders

This article is a part of our Traits of Successful Traders series.

Part One: What is the Number One Mistake Forex Traders Make?

Part Two: When is the Best Time of Day to Trade Forex?

Part Four: How Much Capital Should I Trade forex With?

Over the past several months, The DailyFX Research team has been closely studying the trading trends of FXCM clients, utilizing the enormous amount of trade data at FXCM. We have gone through an enormous number of statistics and anonymized trading records in order to answer one question: “What separates successful traders from unsuccessful traders?”. We have been using this unique resource to distill some of the “best practices” that successful traders follow, such as the best time of day, appropriate use of leverage, the best currency pairs, and more. You can learn more about the project and see further research at the on DailyFX.com.