The Lawrence Chan Blog

"How much money will I make trading Forex?" is the question I am going to answer in this article.

I have posted another article, Position Sizing For Forex Traders and CFD Traders, that serves as the basis on the position sizing that will be used in this article. If you find that the assumptions in the sections below are too conservative to your taste, you can check out that article for the reasons behind.

This article is long so get yourself a cup of coffee (or tea, or energy drink, or whatever) and take your time to read it.

The Importance Of Patience

Many forex traders and CFD traders think that they need exceptional luck to make big bucks trading forex. That is not true. To make good money trading forex consistently, all you need is a half decent trading strategy with matching trading capital. You may not start out with enough capital to make a lot of money in the beginning, but that is not important. What is important is that you have to be consistent in executing your trading strategy so that you can accumulate enough trading capital.

In a sense trading forex and CFDs with very small starting capital is like the professional poker scene. Majority of the professional poker players learn their skills from trading tiny bet size tables. They do not play just a few times or even a few hundred times at those tables to gather their initial stakes for buy-ins to the major poker tournaments. They played thousands of hands to accumulate both experience and bankroll.

These professional poker players can make a decent living by continue playing poker games at tables (both real ones and online ones) offering bigger bet size. But some of them would choose to enter major tournaments to see if they can get a big break. Those who enter the major tournaments using all the money they gathered for the buy-in may not be able to take home any prize money, hence losing all the gains and have to start all over again.

In this case, those poker players are doing the same thing like the forex and CFD traders who raise their position size significantly disregarding the risk of losing everything in the trading accounts. If things work out, of course, the trader would be looking at a significant boost in the available capital to trade with. Well, if things do not work out in the trader’s favour, this trader has to start all over again.

There is no absolute right or wrong in a situation where raising the position size so much that the risk of losing all the money in the trading account becomes a real possibility. Every market scenario unfolding in real-time are different. That is the probabilistic nature of the markets. Just make sure 1. you understand the possibility of losing the account is real and possible, 2. you have considered the consequence, and most important of all, 3. prepared mentally to handle the negative outcome.

Before you get to the point of facing this decision, however, you have to have the patience to grind through the bankroll accumulation process.

Power of Scalability

Forex and CFD trading offer the most flexible position sizing options available to small traders. Hence it is possible to increase position size steadily to improve overall performance. Following is the projected performance of a trader trading euro dollar multiple times a day with average profit of 20 pips per trade expectancy and that the trader would adjust his position size every 100 trades.

Notice that in the beginning the profit per trade is expected at $6. It is a small amount. And many people who do not have experience trading would have the urge to increase their position size quickly so that they can make more money faster. The problem is that increasing position size too quickly will easily ruin the account if it is not done properly. Hence, focus on the the potential and stick to a plan that is reasonable and doable is always better than rushing towards the finish line.

Given the example above, which is not that remote for many day traders who pay attention to the price movement closely, a day trader who do 3 to 5 trades a day will likely reach 100 trades within a month or two. A very consistent trader having a stable strategy and following this plan with no accidents and no deviation from the execution of the plan, would be able to accumulate an ending balance by the end of the year (or by the end of the 600 trades) would be $48,500.

I leave out the calculation on next few levels of position size from the table. If you are paying attention, you will be able to figure that out easily. You will also be able to figure out the profit potential the same way.

This is the power of scalability. The very same trading strategy that generates only $6 per trade on average in the beginning can also generate $264 per trade on average when it is executed with position size of $132,000 instead of the original $3,000. A position size of $132,000 is not a big one in the forex markets at all. Moving positions of size $300,000 to $500,000 is also not a problem during busy market hours. Beyond that, you will have to think about your impact on the market with your orders in illiquid conditions.

Liquidity And Slippage

I just show you a very simple growth plan trading forex. It exists and it is possible to do it. It may take you 6 months. It can take you 3 years. The time needed to get to the point where you have a decent size trading account varies depending on the person. It is not something you can rush.

Just remember that by the time you get to the point of $200,000 position size, you need to stop increasing your position size at the prescribed rate. You have to start working on strategy that enables you to trade even bigger position size, or, diversify into trading other forex pairs.

Why diversify from a winning strategy when it is working so well?

The problem lies in the fact that the approach which works with small account size are mainly scalping strategies. Some people call that trading the flow. It enables you to get a piece of the action in the market and works very well up to certain extend. Such strategies will have execution problem if you try to do it in large scale. Slippage becomes a very real problem when your average profit is just 20 pips and that slippage eats into that by 5 pips or more.

Depending on the brokerage you use and also the exact strategy you are using, you may be able to push the position size larger but eventually at $500,000 range you will have to deal with the liquidity issue still. It is better to resolve the problem by keeping your current strategy to work on a reasonable size so that you have capital allocated for diversification into trading other forex pairs and/or strategies.

The Bottleneck

Consider the transition from the small account size (less than $50,000) to reasonable account size or trading capital (up to about $200,000) as the bottleneck period, it is the the most likely time when a good trader who can turn, say, a $5,000 account, into $30,000 in months, going busted in just a few weeks. A trader who can run the account up 6 times the initial capital is not stupid. The trader obviously has done something right. The problem, however, is that along the way in accumulating the capital, unlike playing pokers, the trader can easily deviate from his original working strategy to optimize for the current market environment.

Even a slight change of a good strategy will drastically modify the risk profile and performance of the strategy. In this situation, however, the trader most likely does not even know he is drifting away from his working method because relaxed money management can often get away in certain market conditions that are more forgiving. Hence it is important for the trader to make sure the trading plan is followed properly.

If the trading plan is followed rigorously but the performance is still slipping, it is important to give yourself time by reducing the position size and observe objectively if the strategy is no longer working, or, it is just one of those periods where the method has a tough time making money.

Diversification

By keeping your original strategy to trade at a reduced position size, you get to give yourself some room to test out new strategies. For example, if you successfully traded your account from $1,000 to $25,000, you may consider lowering your position size to base on just $15,000. Then use the other $10,000 as your capital for testing new strategies.

It is best to keep the position size as small as possible for the new strategies. This time, however, you are not cash strapped to just the $1,000 you start with. You can try out multiple strategies with say $2,000 behind each experiment. As long as you are doing this carefully like how you first started, this will speed up your process in finding new ways to trade your account more efficiently.

Swing To Win

Many professional day traders trading forex make only 50 to 60 pips a day net on average. It is not that much at all. They do not scalp that often as it is easier to maintain multiple positions trading the swings. The take home profit per unit traded stays approximately the same as trading the flow, although with few trades. The reason for the similarity in performance is that capturing swing profits require relatively larger risk per trade which is not feasible with very small trading accounts.

These traders are making decent amount of money because they are doing it with size. Yet, we seldom hear or read anyone telling this simple truth to the beginners. It is their hard earned wisdom. I guess not that many people like to share this.

Those home runs we hear people keep talking about are the glory trades. They are also talking points in social gathering but they are not the norm. Beginners often confuse that these glory traders are the reasons why some traders can make it big. The glory trades are just frosting on top of a sustainable trading career. They are done on the side with limited risk and usually do not affect the daily trading routines of these traders.

Summary

The secret to trading forex successfully for most retail traders is to start small and learn to trade the flow. After accumulating enough capital, the trader will have to learn the next set of skills to master swing trading, even if the timeframe is just day trading. By then, the trader will be able to carry decent position size, making it possible to make a good living off the trading profits.

The income potential of trading forex and CFDs is not that different from trading the emini S&P (see Day Trading Income Potential For Index Trader) with similar trading capital. The difference, however, lies in the transition issue mentioned above.

Traders trading the emini S&P index futures do not suffer from this problem in general because of its better liquidity at each smallest price increment (probably one of the best markets in this aspect) and non-directional volatility (allowing efficient scalping).

Traders trading forex can start out with smaller account size and have the advantage of being able to trade smaller position size and easier to scale up the positions with very small incremental size but have to deal with the slippage issue later if their trading style depends heavily on very small profit targets.

No one can speed up the process of evolving from trading the flow to trading the swings for you. You need the experience yourself so that you can handle changes to the trading environment in the future without going into a panic. As I mentioned many times in my other writings, it takes personal growth to make you a consistently profitable trader.

4 comments

I have a huge collection of scripts, data, indicators, example systems, etc. on hand.

The difficult part is to figure out an organized way to upload these things to the forum.

Or do I really need a plan at all?

Something I have to decide quickly.

Let me know what you think. You can comment here, post your suggestion in the forum (I have started a thread there already) or email me. I will gather the ideas and get someone to organize the stuff.

8 comments

My monthly update on market internals.

The current snapshot of S&P 500 3-Day Advance Issues, Tick16 Short Term + Long Term as of 2013 March 19 close.

Reading

1. Long Term Tick16 (yellow line) below neutral zone but not dropping

2. Short Term Tick16 (red line) moved above the neutral zone

3. 3 Days Advance Issues (green line) diverging from new high printed by S&P

Inference

a. #1 is bearish pointing to overbough and oversold on 30-min chart and higher timeframe can easily result in reversal.

b. #2 points to buying in underlying components near the all time high pretty much continuously.

c. #3 points to a pullback in advance issues back down to oversold zone may be necessary to correct the prolonged period of divergence we experienced over the past month. As long as price can hold a higher low when the advance issue reading is oversold again like end of February, we will get a tradable swing long coming.

Last update predicted we would experience a significant pullback and we got that in late February.

A selloff is now in progress and how it develops from here will determine if the long term price up trend is over or that another leg up is in store for us. Monitor the way how 3 days advance issues is moving will give us the clues.

One comment

Unlike trading index future contracts or commodity future contracts having a steep margin requirement and higher minimum account size across the board, forex trading (and CFD trading) can be done with very small size account. I am not talking about the ability to go for 200 times leverage. I am talking about the flexibility the forex firms are offering that allows the traders to trade with very small lot size to scale the risk properly.

This combination of flexible lot size and high leverage arrangement make it possible to trade forex and CFD with very small initial risk capital and still achieving good performance with proper risk management. The important thing is that the trader has to keep a clear mind and has a conservative trading plan in place. Of course having a good trading strategy will help but it is not the most important factor in trading forex and CFDs successfully.

Let’s see how one can play this game smartly by controlling the position size.

$500 Play

Many traders go into forex trading because of the low margin and next to nothing account size requirement. There is absolutely nothing wrong with that because they are essential features which make forex trading a very good vehicle to make money. The real problem is that most traders do not realize their inexperience in trading require their full attention to protect their capital.

With just $500 put into an account for a test drive of trading forex and CFDs, it is very likely the account will be wiped out quickly not because of consistent bleeding from losing trades, but one to two very bad trades where the trader refused to cut loss. I have seen enough people doing that not just with very small size accounts but also with $5,000 or even $50,000 accounts.

Those who have very small size accounts often blame the wipe out on the fact that if they had put in an extra $500 into the account they would not have been cleaned by the house. I have to admit that it may be true, but for a rare few cases only.  Majority of those who think this way actually would lose the $1,000 instead of just $500 because they played the game wrong. They would face the exact same scenario again and again until they can see the situation in proper perspective.

i.e. blame themselves as oppose to blaming others or bad luck

Stop Loss Size Based On Emotional Tolerance

To avoid triggering the worst trading behaviour, one has to use stop loss the properly way. Proper means making sure the amount being stopped out would not make you so frustrated that you would forget about your trading plan. The stop loss has to be an amount acceptable to you psychologically. That is something I cannot help you with and you have to ask yourself honestly to figure out that.

As a rule of thumb, I find dividing the casual answers a rookie trader provided by 10 as the stop loss starting point is a pretty good one. It is not arbitrary. It is my experience that people usually overstate their emotional risk tolerance.

It does not matter if you start with a $10,000 account or $50,000 account. If you would lose your cool when you are hit by $100 stop loss twice in a row, you have to reduce the stop loss absolute size. The good thing with forex and CFDs is that you can do that by adjusting the position size easily. At smaller position size, you get to keep the stop loss strategy that you know works well instead of finding a stop loss method to meet your more restrictive need.

With something like emini S&P, with limited capital where you can only trade 1 or 2 lots, you do not have the flexibility in position sizing. Hence you must be compatible or you better trade something else. That brings up the issue of index CFDs which are offered by many forex firms. If you like to trade index, the CFD alternatives could be a good solution to the position sizing problem with regular index future contracts.

Overleverage Is Just A Word

At 200 times leverage, $500 can be used to trade up to (or close to) $100,000 position size. I know that most forex brokerages will not let you do that, but that is just minute details. The more important thing that you should pay attention to is the burn rate. Using maximum leverage, each pip will cost you $10 USD on the euro dollar pair. Just one single 50 pips move will wipe your account out with no change.

Using this extreme case, it tells us how easy it is to get an account wiped out if you do not have an exact plan in place to restrict yourself from trading beyond certain sizes.

Affordable Stop Loss Based On Dollar Value Per Pip

So how do you position yourself for sustainability? Apply simple statistics concepts to find out the acceptable survive level will do the job.

Using the magically textbook statistics constant of 30 samples, you can find out the conservative position size quickly. Based on the scenario of losing money 30 times in a row with fixed losses, and the account can still continue to trade, you can work out the answer following the example below.

Let’s say you expect that you need 50 pips stop initially for any open position using your strategy and that you are willing to lose up to $15 per trade (that already adds up to $450, leaving only $50 for margin). So you can afford up to $15 / 50 = $0.30 a pip in reality. It also implies your position size should not exceed $3,000 face value using euro dollar as example. $3,000 is 3 micro lots with many forex brokerages who offer special micro accounts.

Since $3,000 would require only $15 margin at 200 times leverage, that gives you some extra room on the reserved $50 but not quite enough to go for $4,000 position size.

Notice that at $3,000 position size, you are not using 200 times leverage at all. In reality, it is just 6 times your capital. Trust me, it is still very aggressive use of capital, yet improves your chance of survival significantly over using 10 or 20 times leverage.

Always Choose The Smaller Stop Loss Amount

When you have a bigger account to work with, the maximum stop loss amount you can throw behind each trade will increase. For example, if you trade steadily and worked your way from $500 to $5000, you will be able to afford $150 stop loss per trade following the logic outlined in the previous section. That is the maximum your account allows you to but you should not simply increase your stop loss size and position size just because you can. Instead, pay attention to your emotional tolerance level and cap your stop loss amount to one that you feel comfortable with.

It is the other advantage of forex and CFD trading. You can increase your trading size in fractional manner so that you can get comfortable with the risk you are taking and increase your position size gradually right from the start when you have very limited capital. That makes it much easier for small traders to grow into decent size traders. In another words, forex and CFDs provide better opportunities to those who are interested in building a solid trading career comparing to other instruments.

Trading Capital Can Be Different From The Trading Account Size

One practice many pro traders do is to keep liquid asset around for trading. As long as you are discipline enough not using these money for other purpose, these funds can be used in the calculation of conservative position size. What that means is that you know clearly how much capital you are committing behind your trading with a specific brokerage and that you know exactly the leverage you are using. To the brokerage your account could look very aggressive but you know better in this case.

There are many reasons why we choose not to keep large amount of money at a brokerage. One of them is the safety of the fund. After so many problems happened with the brokerages over the past few years. Many of us are much more careful with money put into brokerage accounts. Parking just enough money for trading at the firms and keeping the rest of the liquid capital at bank accounts with deposit guarantee or insurance by US or Canadian authorities gives us a peace of mind. Remember that different countries and regions do have different rules for this type of insurance so be sure to read the fine prints to know what your rights are. And do not park much more than the maximum insurable amount with any single institution if you are extra cautious.

Summary

As a summary, the leverage the brokerage gives you is not your excuse to bet your account irresponsibly. You do have control of your position size. And that is really what matters most. By keeping your position size reasonable relative to the trading capital you have, it will buy you more time to learn to trade before exhausting the trading capital. Once you become consistently profitable, it will also serve you well as your foundation to grow your trading business steadily.

No comment yet

What happened in Cyprus is exactly the type of events I warned about and why money has to be parked in hard assets that are not exposed.

If you do not know what is happening with Cyprus, this is a good Q&A from Guardian,

http://www.guardian.co.uk/world/2013/mar/17/cyprus-savings-levy-questions-and-answers

Update of the event from CBC News,

http://www.cbc.ca/news/world/story/2013/03/17/cyprus-bank-deposits.html

No comment yet