Many people like trading foreign currencies on the foreign exchange (forex) market because it requires the least amount of capital to start day trading. Forex trades 24 hours a day during the week and offers a lot of profit potential due to the leverage provided by forex brokers. Forex trading can be extremely volatile, and an inexperienced trader can lose substantial sums.
The following scenario shows the potential, using a risk-controlled forex day trading strategy.
- Risk management is a critical part of forex trading strategy, usually done with a stop-loss order.
- Day traders want to aim for at least a 50% win rate.
- A higher win rate gives you more risk/reward flexibility, and a high risk/reward ratio means that your win rate can be lower and still stay profitable.
- With careful risk management, an experienced and successful forex trader with a 55% win rate could make returns above 20% per month.
Forex Day Trading Risk Management
Every successful forex day trader manages their risk; it is one of, if not the most, crucial elements of ongoing profitability.
To start, you must keep your risk on each trade very small, and 1% or less is typical. That means that if you have a $3,000 account, you shouldn't lose more than $30 on a single trade. That may seem small, but losses do add up, and even a good day-trading strategy will see strings of losses. Risk is managed using a stop-loss order, which will be discussed in the Scenario sections below.
Forex Day Trading Strategy
While a strategy can potentially have many components and can be analyzed for profitability in various ways, a strategy is often ranked based on its win-rate and risk/reward ratio.
Your win rate represents the number of trades you win out a given total. Suppose you win 55 out of 100 trades; your win rate would be 55%. Having a win rate above 50% is ideal for most day traders, and 55% is attainable.
Risk/reward signifies how much capital is being risked to attain a certain profit. If a trader loses 10 pips on losing trades but makes 15 on winning trades, they are making more on the winners than they're losing on losers. That means that even if the trader only wins 50% of her trades, they will be profitable. Therefore, making more on winning trades is also a strategic component for which many forex day traders strive.
A higher win rate for trades means more flexibility with your risk/reward, and a high risk/reward means that your win rate can be lower, and you'd still be profitable.
Suppose a trader has $5,000 in capital funds, and they have a decent win rate of 55% on their trades. They risk only 1% of their capital or $50 per trade. That is accomplished by using a stop-loss order. For this scenario, a stop-loss order is placed 5 pips away from the trade entry price, and a target is placed 8 pips away. That means that the potential reward for each trade is 1.6 times the risk (8 pips divided by 5 pips). Remember, you want winners to be bigger than losers.
While trading a forex pair for two hours during an active time of day, it's usually possible to make about five "round turn" trades (round turn includes entry and exit) using the above parameters. If there are 20 trading days in a month, the trader is making 100 trades, on average, in a month.
In the U.S., forex brokers provide leverage up to 50 to 1 on major currency pairs. For this example, suppose the trader is using 30 to 1 leverage, as usually that is more than enough leverage for forex day traders. Since the trader has $5,000, and leverage is 30 to 1, the trader can take positions worth up to $150,000. Risk is still based on the original $5,000; this keeps the risk limited to a small portion of the deposited capital.
Forex brokers often don't charge a commission but rather increase the spread between the bid and ask, thus making it more difficult to day trade profitably. ECN brokers offer a very small spread, making it easier to trade profitably, but they typically charge about $2.50 for every $100,000 traded ($5 round turn).
Trading Currency Pairs
If you're day trading a currency pair like the USD/CAD, you can risk $50 on each trade, and each pip of movement is worth $10 with a standard lot (100,000 units worth of currency). Therefore, you can take a position of one standard lot with a 5-pip stop-loss order, which will keep the risk of loss to $50 on the trade. That also means that a winning trade is worth $80 (8 pips x $10).
This estimate hows how much a forex day trader could make in a month by executing 100 trades:
- 55 trades were profitable: 55 x $80 = $4,400
- 45 trades were losers: 45 x ($50) = ($2,250)
Gross profit is $4,400 - $2,250 = $2,150 if no commissions (win rate would likely be lower though)
Net profit is $2,150 - $500 = $1, 650 if using a commission broker (win rate would be like be higher though)
Assuming a net profit of $1,650, the return on the account for the month is 33% ($1,650 divided by $5,000). That may seem very high, and it is a very good return. See Refinements below to see how this return may be affected.
Slippage Larger Than Expected Loss
It won't always be possible to find five good day trades each day, especially when the market is moving very slowly for extended periods.
Slippage is an inevitable part of trading. It results in a larger loss than expected, even when using a stop-loss order. It's common in very rapidly moving markets.
To account for slippage in the calculation of your potential profit, reduce the net profit by 10%. (This is a high estimate for slippage, assuming you avoid holding through major economic data releases.) That would reduce the net profit potential generated by your $5,000 trading capital to $1,485 per month.
You can adjust the scenario above based on your typical stop loss and target, capital, slippage, win rate, position size, and commission parameters.
The Final Word
This simple risk-controlled strategy indicates that with a 55% win rate, and making more on winners than you lose on losing trades, it's possible to attain returns greater than 20% per month with forex day trading. Most traders shouldn't expect to make that much; while it sounds simple, in reality, it's more difficult.
Even so, with a decent win rate and risk/reward ratio, a dedicated forex day trader with a decent strategy can make between 5% and 15% per month, thanks to leverage. Remember, you don't need much capital to get started; $500 to $1,000 is usually enough.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.