Many retail traders have a short term view of the financial markets, but do not pay much attention as to how they can profit from the market in the long term. One such strategy which enables traders to make a little capital go a long way in the FX market is by the use of the compounding principle.
Albert Einstein called it the greatest mathematical discovery of all time. We are about to see why. Compound interest is a system where capital and its returns are re-invested using the same or lower amount of risk, in order to get a multiplied sum in future. At some point, the percentage returns may remain the same, but the monetary value of the percentage returns increases with time. That is how compounding in forex works. To demonstrate this, we will use an excel sheet into which a rate of return and a starting capital have been computed, and we shall see how this amount compounds itself over a period of one year and beyond.
How Compounding Forex Works
Here is a snapshot from the MS-Excel document, which shows the starting capital of $5000 on the left, the rate of return (12.5%), and the figures that will result from the attainment of the returns on a month-by-month basis for one year, as well as annual returns into the 2nd, 3rd, 4th and 5th years. The figures representing the capital and the rate of returns can be adjusted manually by the trader, and the formulae that have been input into the returns fields will be automatically adjusted.
Things will usually be quite slow in the 1st year and this usually leads to discouragement on the part of many participants in a compounding challenge. But if the challenge is continued and the trader perseveres into the 3rd year, that is when returns really start to get amazing. A monthly return of 12.5% is actually quite achievable, as this is a use of very low risk with far reduced chances of losing an account. All it requires is sticking to monthly targets with a lot of discipline. Let’s crunch the numbers.
Starting capital: $5000
There are 20 trading days a month. But we will cut this down to 12 days a month, trading only on Tuesdays, Wednesdays and Thursdays, which are the days of maximum volatility and trading activity in the market.
This equates to an approximate target of 1% a day. So if you start with $5000, and your expected monthly profit is $625 (based on a return rate of 12.5% a month), this equates to $52 a day (based on 12 trading days a month).
The total capital available at the start of the 2nd month is $5,625 ($5000 initial capital + profit of $625). The 2nd month’s profit of $703 requires a gain of $58.60 a day, which is about 1.04% of the total capital of $5,625.
Let’s fast forward to the end of the 1st year, where the month’s profit is $2,568.88. This equates to a daily profit of $214, which represents 1.04% returns. Now compare a monthly return of $625 in the first month, and $2,568.88 return in the 12 month, all while still the monthly return rate is 12.5%. That is the power of compound interest and that is what traders who really want to profit from the market should aim for.
How to Actualize the Compounding Strategy
In actualizing the compounding strategy, a number of things must be considered and put in place by the trader. One of those factors is risk management. Risk management experts all agree that no more than 3-5% of a trader’s capital must be committed to ALL active trades in an account. With new leverage requirements now imposed by the European Securities and Monetary Authority in Europe, brokers in the EU now require far more capital than ever before to be able to maintain positions.
Let us assume that the rate of return being targeted is 12.5% a month, or 1.04% a day. If the starting capital is $5,000, then the day 1 profit should be a minimum of $52. So the question is: what lot sizes should you use in order to achieve a profit of $52 for the 1st day, using a capital of $5,000?
1 mini-lot has a value of $1 per pip. So you would be aiming to make 52 pips on day 1. But let us assume the trader wants to use a lot-size of 2 mini-lots, or a trade value of $2 per pip; this means only 26 pips would need to be targeted. The cost of setting up a 0.2 lot size trade (2 mini-lots) on an EU broker’s platform (using a leverage of 1:30) is $666. This is more than 10% of the trader’s capital, which goes against the risk element for the trade. So the trader has to step down the lot size. 0.08 lots or 8 micro-lots, would require a capital of $266 to setup the trade. This conforms to the acceptable risk management profile of between 3-5%, as $266 is 5.32% of the account capital.
If you use a broker outside the EU, the generous leverage requirements will allow you to set higher lot sizes than would be possible with an EU broker.
The compounding strategy has some advantages and these are as follows:
- Compounding enables a trader to use a low-risk method to achieve high returns.
- It is a sustainable way of trading forex.
- It allows traders with small capital to build up capital over time without putting themselves under pressure to generate such capital from external sources.
The compounding strategy is worth trying. The best time was yesterday. The next best time is probably now.
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