Compound interest is simply a math principle that helps form those parabolic growth curves that we all aspire to achieve. The power and potential of understanding how compound interest works is of HUGE importance to all traders because of the critical lessons it teaches about your trading and money management.
Compound interest is so powerful because you’re letting your money work for you. Check out the table below for a bit of an idea of just how powerful compounding can be. Let’s assume our starting point is a trading account with $10,000. Let’s also assume we’re trading a system with a winning % of 55%, a position size of 2% and our R-multiple (read our blog in R:R here) is 2. With these numbers in mind, let’s find the trade expectancy.
(Winning% * Position Size * R-multiple) – [(1- Winning%) * Position Size] = Trade Expectancy
(.55 * .02 * 2) – [(1-.55) * .02] = .013 or 1.3%
The answer should be 1.3%, which means that every trade you place has an expected outcome of 1.3% in the long term.
Now, what does this mean to our trading account? Well, with our $10,000 account, the first trade you make has an expected outcome of $130 profit. Factor in a few more trades and your account is now at, say $15,000 and now the 1.3% expectancy is equal to $195 profit per trade. Whilst this gain isn’t huge, it’s important to remember that you’re not doing anything different, but you’re making more money.
Winning%: 55% | Position size 2% | R—multiple: 2 | Account: $10,000
Let’s say your MT4 account is now at $20,000 and that expectancy per trade is now $260. The growth is slow at this stage, but regardless, it’s growth. This period can be tough to get through because you’re not necessarily seeing the huge profits and it’s a bit of a grind, but sit tight and keep plugging away.
So the slow growth period is coming to an end and you’ve hit 200 trades. That $130 per trade is now worth $1,700 per trade, and you’re not working any harder or doing anything different at all… just following your usual trading routine. Another 300 trades later and that 1.3% is worth a monster $81,000 per trade. Now that’s some super compounding power.
*It’s important to note that trading a large size can have drawbacks depending on your instrument of choice. Any illiquid assets are likely to be affected by your buying & selling at a large $ trade size.
Practice Perfect Patience
The most important component when compounding trade profits is patience. Newbie and amateur traders belt out a few calculations and then become too fixated on the potential profits that are 3-400 trades away, when the reality is they’re just frustrated because their $2000 MetaTrader 4 account isn’t giving them the returns they’re chasing.
Your trading journey should be slow and boring, if you want a rush and excitement then you’re not cut out to trade for a living. Compounding only really starts to take effect once your account reaches a certain size, which is why most traders never get there… they give up too early or switch trading systems willy-nilly with the expectation of larger returns, faster. Accept that you will not make a life-changing amount of money in the short-medium term and exercise perfect patience for the potential of HUGE rewards in the long term.
Consistency is Key
When you finally realise that you need patience, the only thing left to do is apply consistency. As a trader you need to bring your game every day. Even when it looks like your account won’t ever grow to any significance because the power of compounding it proven to work every single time without exception.
Source: Vantage FX Blog