Risk Capital and Realistic Expectations

You should not put any money into trading Forex that you cannot afford to lose. That is the conventional wisdom, and we will dispute it a little later. Still, the probability of an unforeseen risk striking a blow to your Forex trade is very high. Risks include:

• a random move caused by another trader with a really big position opposite to yours;

• shocking comment by a central banker or minister of finance;

• natural disaster, war, or act of terror;

and most of all,

• your failure to place a reasonable stop.

Risk capital is called “risk” capital because regular capital is considered at only ordinary risk of loss. Risk capital has to have a high return to compensate for its placement in a risky security (Forex). As a general rule, risk capital should comprise no more than 10% of your total capital. This means you would have to have $100,000 in savings to be comfortable trading with a starting risk capital stake in Forex of $10,000.

Whether Forex is actually riskier than other securities is debatable — if you look at the variability (using the standard deviation) of Forex against equities, you can find plenty of riskier assets, especially emerging markets and many commodities, usually due to low liquidity. But the high leverage in Forex multiplies risk, and thus if you lose 50% of your starting capital stake, you need to make 100% to get back to your starting point. We expect to make high returns in Forex, but not 100% and not in a single trade.

Therefore, it is important to acknowledge that when you speculate in Forex, this is not your father’s mutual fund. So, how much capital do you really need to make the effort worth your while? It should come as no surprise that if you do the work — learn the fundamentals, the technicals and the sentiment readings; draw really good charts; practice-trade for a good long time; size your positions properly; place stops and targets properly, and keep your head about you — you can manage the risk in Forex.

This is why the conventional wisdom — do not trade with any money you cannot afford to lose — is not right for everyone. It is no doubt right for 99.99% of beginning traders who do not take the time to do the work, but if you are one of the exceptional ones, you can allocate more than the usually recommended 10% of total capital to trading Forex. Even so, you should probably start out with 10% and increase it to no more than 50% of total capital.

Capital Stake

Every single beginning trader falls in love with the magic of leverage and starts imagining splendid profits at high multiples of starting capital. Begin with $1,000 and end up with $100,000 a year later! Obviously this is unrealistic, but how do you arrive at what is realistic?

The right question here is how much money you want to make as a multiple of starting capital.

Capital Goal = Starting Capital + (Expectancy × Capital Stake per Trade × Total Number of Trades)

To get a fuller understanding of “expectancy,” see the lesson on risk-to-reward ratio. In a nutshell, it is the amount of gain you can reasonably expect to make per trade net of losses.

Let’s say you have $10,000 to put into Forex trading and you want to double it over a year to $20,000.

We have two variables to play with here: what is your average gain net of losses and how many trades do you plan to make per year?

Let’s say that you believe you can make $130 per trade net of losses. Here’s the arithmetic:

$20,000 = Starting Capital + ($130 x number of trades)

If you traded the full amount of $10,000 on every trade (and the expectancy remains stable at $130 per trade), you would have to make 76.9 trades per year to double your money:

$20,010 = $10,000 + $10,010 ($130 x 77)

A total of 77 trades per year is probably too few, and an expected gain per trade of $130 is probably too high. Besides, you would not put all your capital on your first trade (or any single trade) in the first place. What if the trade is one of the losers and you know you can expect to lose 45% on any losing trade? Your capital take is now $10,000 minus $4,500 = $6,500. Now you are no longer seeking to double your stake but to more than triple it.

Second, the number of trades per year is largely dictated by how much time you have to devote to trading and on the system you select. If you are devoting all your time to trading, a more likely number of total trades is at least 240 (the number of trading days in a year), or a multiple of that if you plan to trade the same move several times in the same day. Now, if you allocate $2,000 (or 20% of total starting capital) to your first trade and you average return net of losses is $30, we get:

$30 x 240 = $7,200

That assumes you keep each trade at $2,000 and do not pyramid gains into the next trade (or top up the $2,000 from the remaining capital). Pyramiding is also called the Martingale strategy because it multiplies the amount at risk exponentially. Technically, a Martingale trader is a gambler who doubles his bet after every loss, so that a win recovers all the previous losses plus the original stake. Statisticians have spent a lot of time proving that the probability of a catastrophic loss is fractionally higher than the probability of a final win, for various reasons, including the unhappy truth that markets sometimes deliver a string of losses randomly, just like a roulette wheel.

In order to calculate how much capital you need to have to make the gain you would like to see, you need to know your expected gain and the frequency of your trading. We have four variables on the right-hand side of the Capital Goal equation. If you alter them progressively from one end to the other, you will find the combination that suits your risk appetite. Just be sure it suits your skill level, too.