One of the things that attract new traders to FOREX is the availability of trading accounts with high margins. A margin is just a fancy word to denote the amount of money you can borrow for each dollar you have in your account. For instance, in the case of a 100:1 margin for each dollar you have in your account, the entity with whom you open your trading account will lend you 99 dollars to sell or buy $100 dollars.
Depending on the entity you open your trading account with, your need to trade at least a given number of dollars (or units of another base currency). This is called a lot. The standard lot is $100K, but there are smaller lots (10,000K and 1K) that are now available. There are even trading entities where you can choose any size you want from $1 and up. If you have a limited budget, the latter entities are your friends for reason that will become apparent latter, and your should pay attention to it.
Now suppose that you want to buy $10K of USD/JPY. In the case of 100:1 margin, you will need $100 to open the trade. If the USD/JPY appreciates by 1%, you will make $100 profit. But if the USD/JPY depreciates, you will lose money. If for instance the USD/JPY loses 0.5%, then you will lose $50.
If you had only $100 dollar in your account at the start, then if you win in your first trade your account will increase to $200, but if you lose it will shrink to $50.
If your trading account accepts only lots of size of at least $10K, and if your first trade was a 0.05% loser, you cannot place another trade since you will not have sufficient funds. You will need an additional $50 to meet the margin requirements (you need a total of $100, and since you only have $50 you will need another $50).
Suppose that you have a 50% to have a winner trade, and 50% chance to have a loser trade. The winner makes 1%, the loser loses 0.05%. This is in general a winning scenario, but as we will see the new trader can end up losing because of a lack of understanding of margin and other things.
As noted above when the first trade was a loser, we could not continue if we start with $100 only. This means that we need more money to start with to make sure that you do not (or make the chance of such scenario very small) run into the problem of not having enough money to continue trading. We want to make sure that the risk of ruin is small, and the initial budget plays a role in this.
The chance of having 20 successive losing trades in the example of this article is roughly one out of a million. Suppose that we take this risk, meaning we will assume that we will not be the unlucky person to experience a streak of more than 20 successive losses. At loss number 20, we would have lost $1000. Since we must be able to make trade number 21, we will need to start with at least $1100.
Now in a typical ad on the internet, trading entities ask for only $250 to start trading. Five losing trades will wipe out a trader that starts with only $250. The chances of this happening are 1 out of 32. This means that for each 32 traders who start with an account of $250, on average, at least one will be wiped out, not because of the trading system but because such individual did not have enough capital to survive the successive losses until the law of the average brings winners.
If the $250 account was opened with a trading entity that allows for $1K lots, the traders will have better chances if they trade one lot at a time. It would take 48 successive trades for a trade to be wiped out. This will happen to only one trader out of 256 trillion traders! The chance of this happening is practically zero and it would take centuries for this to take place.
The point you should take from this is that your initial budget is critical in being a winner in trading Forex. For a given margin, a given percentage loss on a trade, the probability of a losing trade, and the minimum lot you can trade, you can compute the initial budget you will need.
From a practical point of view, you should allow enough number of trades in order for the law of the average to take place. In the order of 25 trades should be able to reveal an acceptable estimate of the average return on each trade. If we assume to take the risk of N trade without a winning trade, then we will need as initial budget:
S/M+ N*L*S,
where S is the lot size, M the margin, L the loss fraction.
If we divide the margin by the initial budget, we obtain roughly M/(N*L*S). In the above example this is equal to 100/(20*0.005*10000) which is 10. Therefore, we really do not need 100 as a margin but rather only 10 in this example.
Since we do not need more than 10 as a margin if we want to trade properly and be a winner in the example above, then any higher value might hurt a new trader who does not understand and/or appreciate the effect of margin on trading success.
Now if you are given a margin value, you also want to make sure that you only use a fraction F of the account balance in any one trade such that the amount you would lose in any one trade is less than your budget divided by N.
This means that M*F*L must be less than 1/N. Or than the product of M*F is less than or equal to 1/(N*L). In the example above this leads to M*F is less than or equal to 10 (=1/(20*0.005)).
In conclusion this article shows you how to select you initial budget, and how to select the right fraction to trade for a given margin M. The formulas to use are:
1. Initial budget: S/M+ N*L*S
2. Size of each trade: S
