“How much money can I make in Forex?” This is probably the first question a beginner makes, and it’s a completely valid question. Why invest my time and money into something, if I have no idea what the returns will be?
The truth is that Forex is an enormous market, with many interests behind. It’s usual to see brokers trying to “sell” the maximum they can as if it was like a gold mine, where you can get fast and easy results. In fact, beginners may have some trouble in finding viable resources. It’s easy to fall in the many traps in this business, and develop incorrect expectations since the start.
Returns and Risk is the Key
The returns you make, vs the risk you take, is really the key point. Even though it’s possible to have a 1000% return in one year, that would mean incurring in a lot of risks. To have this kind of returns, a trader would need to risk almost all of his account into one single trade. The problem of this way of trading is that it would be very difficult to survive over the long-run.
In the table below we present the bankruptcy probability or risk of ruin. On the top row it’s the win-rate and in the left column the risk/reward ratio per trade. As you can see, the key to winning in this game is to have a higher risk reward ratio. This will assure that, even if you have a low winning ratio, you won’t go broke in the long run.
So, for instance, a trader with a win-rate of 30% and a risk/reward of 1:1 has absolutely no chance of succeeding for long. However, if we keep this same win-rate but increase the risk/reward ratio to 3:1, the probability of bankruptcy drastically drops to 27%. Of course, the risk of going bankrupt decreases with an increase in the win-rate and in the risk/reward rate.
Given that the win-rate of an average trader is somewhere around 50%, a risk reward ratio of around 1.5 is sufficient to almost eliminate the risk of ruin. However, the best is to always aim for the best risk/reward ratio, to keep the odds on your side.
How Much Do The “Big Guys” Make?
To get a sense of what you should expect is to know how much the best in this industry make. The list presented below shows the annual return as from 2014 of top performing Forex Hedge Funds.
And how does Forex compare to other markets? The next image shows equities, commodities and other markets hedge funds returns between 2014 and 2016:
Some claim that it’s easier to make money trading Forex because of high leverage, which allows to take more out of a movement. But as you can see, the annual returns between top hedge funds are similar between different markets. This goes to show that it’s all about return vs risk: while leverage offers more potential return, it increases the risk in the same proportion, which makes it a meaningless factor to judge the results.
How much should you expect?
A realistic return for a solo trader is around 20-40%/year, on average. A trader can sometimes get 100%+ or more in a given year, but unless you are a full-time trading expert, you shouldn’t expect to get this type of returns on average. And if you think about it for a moment, even if you start with a small amount, with a 20-40% return per year, you can build a small fortune after a few years. This is because of the compounding effect.
The image below shows, using this calculator, how you can easily simulate how much will your account grow in the future.
For example, starting with $5000, and with a 40% return per year, your account will be worth $35.000 in 5 years, for a total return of 700%!
Now let’s assume that you even start with a more modest bankroll, such as $500, and you add $200 each month, with a 30% annual return. After 5 years, your account would be $30.000! Add more years and more money into the equation, and you can see how the compounding effect makes good traders become rich, even without having absurd yearly returns.
Taking a Look at a Scenario…
Now that you know how much is possible to get, on average, let’s take a look at a simple example.
Assume a scenario in which a trader has a $1,000 account and an average win-rate of 50%. An acceptable risk per trade is usually between 2-5% of your account in one trade. In this case, this trader would risk a maximum of $30 per trade. A 1.2:1 risk/reward ratio means the trader would place the target price at 1.2x the distance from the entry price of the stop-loss. If the stop-loss is placed 5 pips below the entry price, the target price has to be placed 6 pips above the entry price. This assures winners will be bigger than losers since the reward on each trade is 1.2 times greater than the risk.
With a limit of 2% per trade, this trader will only risk a maximum of 20$ per trade. This means he will lose $20 each time prices hit the Stop-Loss. On the other hand, he wins $24 if prices hit the Take-Profit.
Without commissions, growth profit would be $60 per month.
This is a 6% rate in a month, which can be considered very good. If we take into account compounding, a 6% rate per month means a 100% return per year! Of course, this is not a completely realistic return, as this example didn’t take into spreads and variability in each trade’s outcome. However, it gives an idea of the importance of having a higher risk/reward ratio. By doing this, any trader can aspire to have an expected return of 2-3 digits per year.
What Does It Take To Get Good Results In Forex Trading?
We’ve seen already how much is on the line if you have a good strategy. But what do you need to be successful in this game and achieve higher results? We consider these 4 points to be fundamental:
- Good market knowledge: It is essential to know how prices and volumes work, as well as which are the different players and what relations exist between markets. This will allow you to always be conscious of everything that’s happening around you and make you open the right positions.
- Have a probabilistic mindset: Trading is an unknown activity when it comes to the future. You can have several months with bad results but that doesn’t mean your strategy is failing. You need to keep developing your strategy to achieve better results in the future.
- Don’t think of trading like gambling: Forex is a business like any other. If you make good investments, you should expect a good return. If your attitude towards trading is to gamble like in a casino, the chances are, that you’ll end up blowing up your account!
- Consistency: Once you develop a good strategy, take advantage of it to be consistent with your results. A good strategy enables to achieve consistent returns over time.
The Bottom Line
Wrong expectations about returns usually lead to taking a lot of risks, which translates into a higher probability of losing the whole account. All traders, especially beginners, should be aware of how much they can get and what are their limitations. A trader who claims to have returns of 300%+/year on a consistent basis by trading Forex can only be a genius or a liar, and there are very few geniuses! The very best traders who are able to have outstanding returns for a long period of time usually have returns that don’t even match 100% per year.
The final takeaway is on the importance of establishing a strategy with a higher risk/reward ratio. A higher ratio allows you to lose more trades than you win and still earn money. This will give you an advantage over time.
The ultimate goal in trading is to have the highest return for the minimum level of risk. Money management is the calculation of risk and reward in any trade, to maximize efficiency. In this article, we explain why money management in Forex trading is truly important to improve your results and what strategies you can adopt. Find out why it’s important to know your risk profile and how you can manage risk vs reward accordingly.
Money Management – The Basics
Every trader is different. As such, the way different traders manage their accounts will vary a lot. However, independently of the type of trader, there are some common principles of money management in Forex trading that apply in every situation.
- Determine how risky is the trade – This one is especially important for risk-averse traders, but also apply to others. Before opening a position, you should always evaluate what are the risks involved. You don’t want to lose all your account in just one trade, so always evaluate the worst case scenario first. There are some trades which are simply not worth the risk since the expected return is relatively low. These trades should be avoided.
- Determine how much risk are you willing to take – Once you assessed the risks of the trade, it’s time to decide if you are willing to take that risk. Some traders prefer to take larger risks in exchange for a higher return. Others prefer to have smaller but safer profits. Understand what type of trader you are, and develop a strategy according to that.
- Check the relation between risk and reward – Finally, after deciding if you are willing or not to bear a higher risk, you should see what’s the expected return for that level of risk. It’s not worth it to trade a pair which has the same reward as another pair but is riskier. Always choose the trade that offers the best risk-reward relationship.
Many traders fail because they do not create a strategy according to their risk profile. When a risk-averse trader tries to use a more aggressive strategy, he will probably let his emotions control his actions. As explained in our article about trader’s mentality, this is because some traders are less willing to bear major drawdowns. They will probably end up closing their positions at the wrong time, which will make the strategy ineffective.
According to your risk profile, you should set up a maximum amount to each trade. In order to protect your capital, it’s highly recommended not to use more than 5% of your account in one single trade. This simple rule can be very helpful in case the trade goes against you. By risking only a maximum of 5%, you can be sure you’re not going to blow off your account in one single trade. Although the 5% is a standard measure, some traders may find it better to establish a lower percentage, like 1% or 2%, which is also fine.
To calculate these values, you can use the FXPro’s calculator. In Stop Loss Take Profit Amount, you can select the pair you want to trade and place the respective levels of Stop-Loss and Take-Profit. The calculator will automatically give you the Drawdown and the Profit according to the lot size.
Managing Risk and Reward
As already mentioned, an efficient trade is the one that maximizes reward to a certain level of risk. But how can you do this? In fact, there are some strategies worth noting to manage risk against reward.
This is a widely known and used ratio to evaluate the relationship between the risk of a trade and its expected return. If you’re trading a pair which is at 0.9 and you place a stop-loss in 0.85, you’re risking 0.05. On the other hand, if you believe the pair is going to 1, your expected return would be 0.1. In this case, the risk/reward ratio is 0.05:0.1 = 1:2. This means that you can make a profit even if just you win more than 33% of the times!
Define your stop-loss before opening a position
Stop-losses are important to set a limit to your losses. The location of your stop-loss may vary according to the amount you’re willing to lose if the trade goes wrong. However, there are some simple techniques to define its location. Generally, stop-losses should be placed a little bit under the closer support. This will guarantee that it will only be triggered if there’s a breakout. If the trend touches the support and rebound, you will benefit from this reversion. You can also know more about the support/resistances indicator here and download it here.
As mentioned above, it’s recommended to define a stop-loss before opening a position. However, to protect your capital while the trade is open, move the Stop-Loss as the trade goes on. If you already have a profit from an open trade, don’t risk to lose it all if the trend reverses. As the trend goes up, establish new SL levels closer to the current price, below the most recent short-term support. In this way, you won’t lose everything in case there is an abrupt reversion.
The Bottom Line
Any successful trader should be aware of how money management in Forex trading is essential to get better results. Traders should know what is their risk profile and define a strategy according to it. Compare the risk of a trade against the return to check its efficiency and guarantee the best reward. Ratios like the Risk/Reward are very useful to do this, as well as defining a Stop-Loss and move it during the trade.