Trading is about making money, otherwise nobody would be doing it. Well, maybe few purists would still engage in the process for the “challenge”, but they are in a minority. Most of market participants seek profits. Generally it is accomplished through creating winning strategies. This process is being constantly improved and refined in a pursuit of ever better method, which, logically, should lead  to increased returns. Productive systems are necessary in order to have positive outcome to trading, but once that is accomplished, other steps can be taken in order to maximize total return on our trading capital. One of them is compounding.

What is compounding? Investopedia defines it as  “The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings”. Most people are familiar with in concept when it comes to mutual funds or 401K investments. Money earned in these instruments is typically left in them, to be reinvested by managers. Passive application of this principle, when an average investor leaves the compounding to others. However, active traders, including most Forex market participants, should do it in their trading account, and on regular bases.

In a simplest form, compounding would involve increasing trading size as soon as account value makes new high. Concept is easily implementable while trading stocks, because one could buy, or short sell, any odd number of shares that account size allows. Doing it in currencies is a little more complicated, however, due to lot size and difference in offerings form broker to broker. Vast majority of retail traders have to use leverage to some degree in order to trade standard size lots. This has to be taken into consideration when planning how compounding should be employed in one’s account.

An average Forex trader might have about $10,000 to open an account with. In order to trade full size lot of 100,000 currency units, 10 to 1 leverage is used. This is also very typical among currency traders, as studies indicate, and is the ratio used throughout this post. No claim is made that this is “correct” leverage. This level was used in following examples because most traders can identify with it and makes the math easy. Compounding applies in the same way to any margin level as well as none at all.

Benefits of compounding can be easily noticed when demonstrated on three hypothetical accounts. Each one of them has a starting balance 10,000 and its growth is followed through 3000 pips gain achieved through trading. Time is of no interest here, no stipulation is made about how long it took to make these pips. For clarity of presentation, equity in accounts is recalculated in 100 pips increments. Accounts using maintain their leverage ratio of 10 to 1 as they increase in size. Also, $10 pips value for standard lot is assumed and $1 for a mini.
 

First column shows gains in pips from 0 to 3000, broken into 100 pips steps. Second column shows what happens to an account which trades standard lot without ever compounding- increasing position size. Each pip has a steady value of $10, so every 100 pips bring additional $1000 to the account. After our trading brought in 3000 pips, account grew to $40,000.  Since no size increase took place, growing account balance effectively lowered leverage from 10 to 1 at the beginning to 2,5 to 1 at the end. Trading with no compounding at all.

Column three demonstrates what happens to an account of the same size, using same leverage, but increasing size when equity level allows. This is a hypothetical situation with a broker which offers only standard lots for trading. In this scenario we can trade 1 lot for each $10,000 in equity, sticking to our targeted leverage. At first nothing interesting is happening, until equity doubles. At this point two lots can be traded, which means about $2000 increase for every 100 pips earned. This means only 500 pips to in order to make next $10,000, which allows us to increase position size again. And so on. By the end of the experiment we can see dramatic difference compounding made. $113,000 as opposed to $40,000 for an account without compounding. Same strategy, same number of pips earned, yet vastly improved end results.

Last column shows what would happen to an account with a broker which offers mini lots, as well as full size. In a situation like this, compounding will have even more pronounced effect. We could increase trading size as soon as account gains $1000, which would happen after only 100 pips. In this situation, compounding happens much more often as is more dynamic than before. And so are the results. By the end this account would have grown to $174,000, much more than when trading only standard lots, and dwarfing the results achieved without compounding. In fact, it should be even higher. This table was created in 100 pips increments. Trading mini lots would have allowed for much more frequent size increases, especially towards the end, when we could another lot with every 30, 20 and even 10 pips gained. Had that been applied, account would have mushroomed to well above $200,000. Regardless, above examples should clearly demonstrate benefits of compounding.

Here is the same data in a graph format. Blue bars represent account traded without compounding at all, red bars show progress of account with compounding and trading full size lots, while green bars track account traded with brokers offering mini lot. Once again, last results are understated for reasons explained previously. It still shows how dramatically different final outcomes are.

This simple demonstration didn’t take into consideration time, distribution of wins and losses, depth and length of drawdowns, exact increments of gains, number of pips in an average winning trade and other such factors. Obviously trading strategy must be profitable to begin with. However, once we have a method which is even moderately profitable, results can be greatly enhanced over time by simple compounding. What we need is a broker which allows trading in mini lots, which most do.

Some brokers offer micro lots or trading in any odd lot sizes. This is even better, because position could be increased by appropriate amount every time account makes new equity high. It would lead to farther total return improvement over time. Exact numbers are difficult to project, because of some variables, like those mentioned in last paragraph. Bottom line is, compounding as often as possible is very healthy to every trading account, regardless of strategy  used.

Mike K.