The foreign exchange market, or forex, is the platform where one currency is traded for another, usually for commerce or trade purposes. The forex market converts currency based on its current value, enabling global investments and trading to occur. Currency prices fluctuate throughout the day based on their supply and demand. The forex market lets traders buy and sell currency to make a profit. But how much should you invest in forex trading?
How much you invest in forex trading depends on whether you plan to be an active or passive investor. If you plan to generate an income stream to live on, you need to start with enough money available to trade. But, if your desire to start forex trading is more of a hobby or something to do in your spare time, a smaller amount will be sufficient.
When investing in forex trading, you should limit the amount of a single trade to an acceptable level of risk. But how much risk should you take when trading on the Forex market? If you plan to trade on the forex market actively, does that change the amount you should invest? If you are just starting out or plan to trade in your spare time, should you invest less? Is there a minimum investment you can make to start trading on the forex market? This article breaks down the answers to these questions and more.
What is the Forex Market?
Before you decide how much to invest, you should understand what the forex market is and how it works. General knowledge not only helps you stretch your investment, but it can also help you decide on the right amount to invest in trading.
Forex allows you to buy or exchange one currency by using another. For example, when a US-based company wants to purchase goods from Japan, they use the forex market to convert the US Dollar (USD) into the Japanese Yen (JPY) to make their purchase.
The forex market also supports market speculation where traders can buy and sell currency to make a profit. Traders speculate that the value of one currency will rise in value compared to another.
Since the forex market is used around the world, it is active 24 hours a day. In 2019, it traded an average of $6.6 trillion (about $20,000 per person in the US) dollars every day (Source: Statista).
How Does Forex Trading Work?
Traders make money trading on the forex market when the currency they invest in rises in value compared to another. The most popular currencies include the US dollar (USD), the Euro (EUR), the Great British Pound (GBP), and the Japanese Yen (JPY).
Currency is traded in pairs. Commonly traded pairs include EUR/USD, USD/JPY, EUR/GBP, and GBP/USD. In a pair, the first one listed is considered the base currency, and the second one listed is regarded as the quote, or counter, currency.
For example, if you have a currency quote of 1.1056 for a EUR/USD pair, that means that one EUR (base currency) is worth $1.1056 US dollars (quoted currency). If the quote rises to 1.1066, you can now buy $1.1066 US dollars with one EUR. That represents an increase in your investment of .0010.
Factors to Consider in Deciding How Much to Invest
Many of us have a general idea about how the stock market works. Whether or not you make money depends on what you’ve paid for the stock and how much it is worth today.
Trading on the forex market is similar in that the amount of money you make (or lose) depends on what you’ve paid. However, trading on the forex requires you to look at different factors such as the value of the currency, the number of units you invest in, and how frequently you plan to trade. It also differs from the stock market because you typically don’t hold the investments for a long time.
Currency is traded in a set number of units, commonly referred to as a lot. Most currency trades are conducted in lots of 100,000 units.
Using the example above, the currency quote of 1.1056 EUR/USD and later increase of .001 is for one unit. If you purchased a lot of 100,000 units, your profit would be $100 (100,000 x .001).
If you plan to trade regularly and make a substantial investment, the most effective lot size is 100,000 units. In some cases, this lot size may be the minimum requirement for you to make a trade. The typical investment at this level is $25,000.
For some investors, a considerable lot size may be outside of their comfort level. Someone new to forex trading may also find the large lot size too risky as they are just starting out. In these cases, they may opt for a small lot size when trading on the forex market.
Smaller lot sizes include micro-lots, mini-lots, and nano-lots.
- Mini-lots trade with 10,000 units and are good for traders just starting out. A minimum $2,000 investment is recommended for trading at this level.
- Micro-lots trade at 1,000 units. This small lot size is also suitable for new traders. Trading at this level typically requires an investment of at least $1,000.
- Nano-lots are another option for novice traders. They can range from 10 units to 100 units. Many brokers do not offer lots this small, but for those that do: $25 is typically the minimum investment.
Some brokers also offer demo capability, where you can set up an account and test how forex trading works without investing; this is also a good option for a seasoned trader looking to test out a new investment strategy.
Since currency exchanges occur throughout the day, increases or decreases in the value of one currency against another are measured using four decimal points. When the value of one currency changes relative to another, this is known as a percentage in point or PIP.
- An increase of .0001 is known as one pip.
- An increase of .001 is referred to as ten pips.
A pip may also extend beyond four decimal points to include a subscript. This is known as a fractional pip and is used to supply a more exact currency value. Subscripts stand for 1/10th of a pip. Using the figures above, an amount of 1.10562 reveals that the currency is trading at 1.1056, plus 2/10th of a pip.
The changing value in currency is so small that it is measured in decimal points and fractions. The more money you invest, the larger your return can be if you trade at a gain. An increase of one pip, or .0001, yields $10 when you trade one lot (100,000 units). A smaller investment in a nano-lot (100 units) would produce a profit of $.01.
The trading spread for a forex pair shows the relationship between the buying and selling price of two currencies. The bid price reflects what the currency can be sold for, while the offer price indicates the price the currency can be purchased for.
Offer price: To illustrate, assume that the offer price is 1.5000 for EUR/USD. Under this scenario, it will cost you $1.50 US dollars to buy one euro. If you expect that the euro’s price will rise against the dollar, consider making this purchase if you sell it for more than $1.50.
Bid price: Using the same example, assume that the bid price is 1.5000 for EUR/USD. In this situation, one euro can be sold for $1.50 US dollars. If you predict that the euro’s price will fall against the dollar, it can be repurchased for less than what you paid.
Seasoned traders who are well-versed in currency movement may choose to invest more money depending on how comfortable they are with their expectation that the offer price will rise or bid price will fall. New traders, however, are typically better off sticking to a lower investment as they may still be learning how the forex market and currency values work.
How Much Should I Invest in Forex Trading?
The amount you should invest in forex trading depends on what your goals are.
For those looking to generate a substantial income stream, your investment should be higher. Others looking to test the waters and learn how the market works on their own time may choose to stay with a lower amount.
When deciding how much to invest, consider how active you plan to trade on the forex. The changes in the value of currency are minimal. Investors need to make multiple trades to see any real activity in their accounts.
This level of trading activity can require a substantial amount of time and research on your part. If you expect to devote your time and actively trade on the market, a more considerable investment gives you more flexibility to make higher trades.
The customary practice limits a single trade to 1% of the total money you have invested in minimizing the risk exposure. You can easily have multiple transactions simultaneously, but following this rule helps to keep the risk down.
To give you an idea of how limiting your risk works, consider the following:
Investor A and Investor B both have a $10,000 trading account. Investor A risks 25% of their account on each trade. They could lose $2,500 on one trade. On the other hand, Investor B risks 1% of their account when trading limiting their loss to $100 per trade.
Making a Small Forex Trade Investment
A small investment, such as $100, may be useful if you are just starting and want to learn how forex trading works. But there are some drawbacks.
Most currency gains and losses are in fractional cents. If you start with a small investment, you need a lot of trading activity to see any real progress. Traders may feel pressured to increase their level of risk to show a quicker return. This is usually not a promising idea and is contrary to how the forex market works.
Another drawback of small investments is the commissions and fees incurred for each transaction. With a smaller investment, these fees can quickly eat away at your investment balance and limit future trading activity.
Making a Large Forex Trade Investment
There are a variety of benefits when starting with a more considerable forex trade investment.
- If your goal is to generate an income stream, a more considerable investment gives you more work. When you start with an investment of $10,000, your trading level could go up to $100 per trade and still stay under the 1% risk.
- A larger investment gives you the flexibility to buy a larger lot size, which may increase your potential to make money.
- With a higher single trade threshold, your investment will not get eaten away by fees as quickly as it would with smaller trades.
If you are unfamiliar with trading on the forex market, starting with a higher investment may make you nervous. However, if you follow the customary practice of limiting a single trade to 1% of your total investment, you have a reduced chance of losing a large amount of your investment from one activity.
How Do You Maximize Your Investment in Forex?
There are two ways to make money from your investment when trading on the Forex market:
- Purchase a currency at a lower rate if you expect that its price will rise in the future. In this case, the buyer speculates that the price of one currency will rise against the other. If the price increases as expected, a profit is generated because the trader can sell it for more than what they paid for.
- Sell a currency at a higher rate if you expect it to be repurchased at a lower rate. A trade speculates that the price of one currency will fall relative to one another. If they sell this currency at a higher price now and repurchase it at a lower one, they profit on the difference.
What Factors Impact the Forex Market?
Since the forex market has global participation, it is influenced by macroeconomic factors throughout the world. Key drivers that affect a currency’s value include interest rates, international trade, inflation, political environment, and capital markets.
Banks play a vital role in the valuation of currency based upon the interest rates that they set. When banks raise interest rates, it is typically a sign that a country’s economic condition improves. A trader may buy currency in this scenario if they consider it early enough, whereby the currency has not been changed yet. Conversely, interest rates that are lowered can signal that the economy is struggling. Traders may sell this currency as the value is expected to fall.
Trade can affect currency in a few ways. Nations experiencing high demand for their exported goods will tend to see an appreciation in their currency. Appreciation will occur as countries looking to buy these goods will convert their currency to the one that the exporter accepts.
Conversely, countries that experience trade deficits that import goods than they export may see their currency devalued. This results from fewer customers converting their currency to buy from a nation with a trade deficit.
Inflation can impact currency in two ways. In times of rising inflation, purchasing power is reduced. Reduction in buying power can reduce currency values. However, banks may raise interest rates to offset inflation, which may raise currency values.
A country’s political landscape can affect the economy and currency values. Legislation that restricts industry activity may devalue the currency as sales would be expected to fall. On the other hand, governments that express the desire to increase their spending would positively impact currency values as more transactions are expected.
Domestic and financial turmoil can cause the economy to contract, leading to currency devaluations. Elections may also impact currency values, depending upon the political parties and their stance on economic issues.
News can affect currency values. In some cases, the news is planned. Monthly economic reports issued by the government are an example of planned news communications. Depending upon their contents, these reports can have a moderate impact on currency values.
On the other hand, unplanned news can cause far more extreme variances in currency values, especially if the information is positive or very negatives. Due to these events’ surprise nature, there is typically little that can be done other than to watch your risk position.
Deciding how much to invest when trading on the forex market comes down to what your goal is. If you wish to build an income stream that you may live off, going with a more considerable investment amount is your best bet. Those who want to test out the market to see how it works may be more inclined to start with a low investment.
Whichever way you go, be sure to follow the best practices when limiting your trading activity to 1%. Not only can this help you to mitigate the inherent risk of trading on the forex market, but it can also help you hold onto your investment longer.