The forex market grants millions of traders several opportunities to make profits every working day. There have been tales of traders making millions in the market, which may sound very enticing to the beginner trader. However, it is not as easy as trying your luck and making a fortune overnight. Several factors determine your profitability in the markets, such as your risk appetite, your risk management techniques, and the size of your capital investment.
However, it is important to remember that trading forex is a high-risk activity, and it may lead to losses that surpass your initial deposit. In this article, we will explore a plausible day trading scenario to gauge the profitability of this venture.
Managing your risk is one of the most vital elements of a successful trading strategy. As a rule of thumb, you should never risk more than 1% of your account’s equity on a single trade. This means that if your account’s equity is at $5,000, you should never risk more than $50 on one trade.
This may seem almost insignificant to the $5,000, but even the most experienced traders will have losing streaks. Taking a 1% risk reduces the chances of blowing your account on such dark days. Risk management is achieved by the use of stop-loss orders, which we will tackle later in the article.
Analyzing your trading strategy
A good trading strategy should be subjected to rigorous backtesting and forward testing. To gauge its profitability, we consider its win rate and risk to reward ratio. The win rate is the percentage of winning trades over the total trades executed over a given period. For instance, if you make 100 trades on average in a month, and you win 55 of those, your win rate is 55%. Most day traders typically aim for a win rate of above 50%.
The risk to reward ratio refers to the amount of capital that is risked on trade against the capital one stands to gain. For instance, you could place your stop-loss order 10 pips away while your take-profit sits 20 pips away. That’s a risk to reward ratio of 1:2. Ideally, you should never risk more than you stand to gain. This is to ensure that even when your win rate is 50%, your gains are more than your losses, which means you’re still in profit.
Following this logic, when your win rate is higher, you can be flexible with your risk to reward ratio. Conversely, when your risk to reward ratio is high, you can have a low win rate but still, be in profit.
Case in point
Let’s assume we have a $5,000 account and a 55% win rate on our trades. Since we can’t risk more than 1% of our equity on a single trade, the maximum risk we can take per trade is $50. Therefore, we place our stop-loss 5 pips away and our take-profit a cool 10 pips away. This puts our risk to reward ratio at 1:2.
Supposing we trade for two hours every day of the week, statistically, we could make five complete trades in a day. That means all five trades are opened and closed within our daily timeframe. In 20 trading days a month, we’ll have made 100 trades in total.
Most forex brokers will offer a leverage of 50:1 on average. Some will even go as far as 500:1. However, let’s take on the leverage of 30:1. This means that with our $5,000 account, we can open positions worth up to $5,000 * 30 = $150,000. For sound risk management, however, our risk per trade should never surpass $50.
It is important to note that brokers will charge a variable spread that depends on market volatility. ECN brokers will charge a tight fixed spread but will also charge a $2.50 commission for every standard lot $100,000 traded. That means for each complete trade, both entry, and exit, it would cost us $5 in commissions.
Choosing a currency pair
Let’s assume we’re trading the EURUSD, the most popular pair. Since we can open positions of up to $150,000 thanks to leverage, we buy one standard lot comprising 100,000 euro. Since each pip movement for a standard lot is equivalent to $10, our $50 risk threshold places our stop loss 5 pips below our entry position. The take profit is placed 10 pips above, yielding a 1:2 risk to reward ratio.
By this estimate, each successful trade will yield 10 * $10 = $100. Earlier, we established that we’d be making 100 trades each month, at a 55% win rate. This means that our monthly profits would be 55 * $100= $5,500. The remainder of our trades were losses, so the monthly loss was 45 * $50 = $2,250. Therefore:
- Gross profit = $5,500 – $ 2,250 = $3,250.
- Net profit = $3,250 – ($5 * 100) = $2,750. This is assuming we used an ECN broker.
This puts our monthly return at (($2,750/$5,000) *100) = 55%.
Accounting for slippage
In periods of high market volatility, a market order may be executed at a different price or stop loss filled at a different price than that set when making the order. This is called slippage, and it leads to further losses. To account for this, we should reduce our net profits by 10%. This places our net gain at $2,475, or 49.5%, which is still a substantial monthly gain.
The amount of money one can make trading forex depends on several factors, such as the size of their account equity, their risk appetite, and their trading frequency. Typically, you should not risk more than 1% of your account balance per trade. Further, you should ensure your risk to reward ratio is high so that even with a low win rate, you’ll still be in profit.