Theory: Compounding

Good afternoon all and I hope you are having a great weekend!

It has been a while since posting my last theory article, so let's get back on the bandwagon and talk about the trading and compounding. I think it is most traders dream to be able to escape the rat race, tell your boss where to go (that's if you don't like him/her of course) and let you trading skills lead you on the road to riches. I'm also sure a lot of you would have heard the saying "it takes money to make money" (if I hear it one more time .. arrgg), which to me is kind of deflating, why can't someone with very little money make money? Well pleasingly, for all of you that aren't driving a BMW and spending their weekend on their private yaughts, compounding is most likely a big part of your solution, so let's look at why.

The easiest and most used analogy when describing compounding is the good old snowball, which to me, living in "the sunburnt country", is somewhat foreigh so i'll have to draw on the imagination for this one. In trading, compounding is when you add your previous earnings onto your existing account size and adjust your trade size accordingly. Umm ok let me try to explain.

Let's look at the two trading scenarios, let's say you have opened a mini account with $1000US, this traditionally would let you trade "mini lots" or lots of 10,000 in size, where each pip would equal $1 US approximately (depending on the pair). If you make five "mini lot" trades on the GBP/USD, with each trade earning you 50 pips, you would have your original $1000 plus 5x$50 ... so $1,250 all up (as well as bragging rights for your 5 straight winners of course). This is just like someone packing a tiny snowball, rolling it down the hill five times, and each time you dusting of any excess snow that acumulated from the previous roll before rolling it again. (can you tell i'm struggling with the whole snow thing).

Now let's look at the same trades but include compounding in the scenario. Remember compounding is adding the previous winnings to the account and adjusting your lot size according to some rule. So , from the previous example, after trade 1, our account has gone from $1000 to $1050 (50 pips at $1 each pip). A gain of $50 on a $1000 is a return of 5% of your account, so one compounding strategy would be to increase your lot size by the same amount. Now we are trading lot sizes of 10500 (500 is 5% of 10000), so each pip now equals $1.05. This means trade 2, which returns 50 pips now earns you $52.5 instead of $50, moving your account to $1102.50 instead of $1100. In snowball terms, it is like taking that small snowball rolling it down the hill five times, but each time leaving the excess, and just rolling it right back up there to acumulate even more. (gee im glad that snow thing is over with).

... compounding really is a great tool for all those that can't subscribe to "it takes money to make money" ...

Now what we really want to know, what does it mean to the road to riches? Well if you can make let's say a 50% annual return on your account (certainly acheivable), this time in around 17-18 years you will be a millionaire, sipping a cocktail on a beach somewhere in the bahamas (unless you live there, in which case that would kind of be pointless ... anyway). If you can make a 100% annual return then somewhere around 10 years you would make your first million, not bad from $1000US. The beauty of us as traders is we are not restricted to compounding annually, monthly or even weekly as in a traditional savings account or managed investment portfolio, we can actually compound daily, or even trade by trade.

Compounding really is a great tool for all those that can't subscribe to "takes money to make money", and an even better weapon for those that can.

Happy trading!