Many of us traders started trading in the first place to better our lives and achieve success. What’s that well known term that we all love? Financial freedom. Now, of course there’s no such thing as an overnight success, but how many of us really achieve what we set out to achieve when we embark on our journey as Forex traders. You see, we go through the gruelling stage where we learn how to trade Forex just to come up with what almost feels like mediocre results. It leaves you wondering whether those past 6 months of training yourself to master the markets was really worth it, – leaving your career to pursue ‘the life’. Well, the answer isn’t always no, and the 5% of traders who have incredible success stories usually obtain a few skills along the way which help them become great. Now, obviously there are many skills that I could mention but one in particular I am going to talk about in this article is compounding.
Einstein famously called it the ‘8th wonder of the world’, and rightly so because compounding is one of the most powerful weapons in any trader’s arsenal. It is the mathematical phenomenon which can turn small numbers into huge numbers in short periods of time, and yes, the same can be applied to your trading account. So how exactly does it work? A great question, which is better explained through an example.
Let’s assume you have a trading account which has $10,000 in it and you usually make around 1% per win ($100), and you have a net win of about 5 trades a month, so all told you’re making around $500 a month. Now, what most traders usually do is withdraw that $500 and start again the next month with the same $10,000 and aim to make another $500. What a compounding trader would do is to not withdraw those profits, but rather aim to make the same 5% the next month on their now $10,500 account. Their balance on the second month would therefore be $10,500 x 1.05, which is $11,025, a total profit of $1,025. Compare this to what the non-compounding trader’s total profits would be on the second month ($1,000) and you already see compounding at work. Seems a bit anti-climatic right? An extra $25 is hardly going to buy you that new Porsche you’ve been drooling over. Let’s fast-forward a few months:
Month 1= $11,025 Month 7= $14,774
Month 2= $11,576 Month 8= $15,513
Month 3= $12,155 Month 9= $16,288
Month 4= $12,762 Month 10= $17,103
Month 5 = $13,400 Month 11= $17,958
Month 6= $14,071 Month 12= $18,856
Total profit= $8,856
Without compounding you would have made a total profit of $6000, so by utilising compounding you’re now $2,856 better off. A lot more than an extra $25, right? The best part about this is that in percentage terms you aren’t risking any more than you usually would, as you’re risking a consistent percentage of your account on each trade.
A couple of important things you have to remember when compounding are that a profitable strategy is vital, and that you must be a disciplined trader. There’s no point in compounding if you don’t have a statistical edge, as compounding doesn’t have any effect on your win rate. On top of this, a lot of traders who aren’t disciplined get a few months into compounding their account and start to get freaked out because of the increasing lot sizes – but you have to remember your risk percentage hasn’t changed and you aren’t doing anything different from when you were earning $500 a month.
I know there are a lot of traders out there who rely on their trades as a source of income which is completely fine, but this stops you from utilising the power of compounding because you need to withdraw from your account every month. A solution to this is to have another smaller trading account for compounding alongside your main account which you would use for income; on both accounts you could take the same trades but allow for compounding on the smaller one.
If you had a smaller account of half the size of your $10,000 main account and you consistently compounded that $5,000 dollar account at 5% a month for the next 10 years, guess what that measly $5000 dollars would now be? $1,744,559. Remember – working smart is better than just working hard, you started trading Forex as an investment in yourself and becoming a millionaire in 10 years isn’t a bad investment is it?
This article was authored by Forex Central, a website where we teach both beginning and experienced traders more than your average site on how to trade forex. We have a brand new academy section dedicated to doing just that which you can find at www.forexcentral.co.uk. Thank you for reading our article.
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