The Power of Compounding in the Forex Market
If you can be consistently profitable with your trading strategy ā whatever that strategy might be ā you can make big money trading currencies.
There are many strategies for making money in the forex market. As an example, letās consider just one: a 10-pip breakout strategy. The objective in this strategy is to find specific chart patterns which have a very high probability of leading to price breakouts, and then trading those breakouts for a net 10 pips. If you can do this TWICE a day, with a high success rate (say 85%, or better), you can earn 1% per day on any size account, without taking extreme risk.
Then, if you have the focus and discipline to maintain your consistency for 3 or 4 years, you can turn a starter account into significant trading capital. Or you can turn a well-funded initial account into real wealth. Letās look at the numbers.
Letās assume that you have developed a reliable 10-pip strategy. You have tested it thoroughly on paper, and in your live account. Your strategy is 85% successful (17 trades out of 20, on average, are winners). Every trade is structured the same way: 20-pip stop, and 10-pip limit. Your risk/reward ratio is 2:1 (yes, this is reverse money management). On average, you make 2 trades per day. You trade 1 mini-lot per $1,000 of account balance. This means that your risk on each trade is 2% (or less) of your account balance:
1 mini-lot x 20 pips per $1,000 = $20 risk per $1,000 of account balance = 2% risk
Initially, letās say that you have a small, starter account with an opening balance of $1,000. And letās say that you trade currency pairs whose pip value is $1/pip. In the first two weeks, you place 20 trades (2 trades per day x 5 trading days per week x 2 weeks). 17 trades are winners, 3 are losers, and your net profit for the first 2 weeks is:
(17 winners x 1 mini-lot x 10 pips) - (3 losers x 1 mini-lot x 20 pips) = 110 pips = $110
For the 2 week period, your account has grown by 11%, and you have just averaged a gain of a little over 1% per trading day in your account balance. Letās see what would happen if you kept doing this same thing for a year.
There are 52 weeks in a year. Letās say that you take a total of 4 weeks off for holidays and vacations each year. That leaves 48 weeks in the year for trading. 48 weeks x 5 trading days per week = 240 trading days per year. So, the question we want to answer is this: how much would your account grow in 240 trading days, if you earned a 1% per day compound rate of return on your account balance. If you have a pocket calculator that can compute powers and roots, the answer is easy to get: 1.01 raised to the 240-power = 10.89, which says that every dollar in your account at the beginning of the year will grow to $10.89 by the end of the year; and ā¦
your $1,000 account will grow to $10,890 (assuming you make no withdrawals)
Letās assume that you withdraw half of each quarterās profits at the end of each calendar quarter, in order to pay taxes, to sock away some savings in a safe investment, and later to support your lifestyle.
A steady 1% per day compound rate-of-growth in your trading account, with no withdrawals, would produce 81.67% growth per quarter (based on 60 trading days per quarter); but, you are going to withdraw half of this, so your account will show a net increase of 40.8%, quarter-over-quarter. Letās round it off, and say 40% per quarter.
If you kept doing this same thing for 3 years (earning 1% per day, 240 days per year, and withdrawing half of your quarterly earnings at the end of each quarter), you would achieve the following results:
Over the course of 3 years, your little $1,000 account has earned $111,400, of which $55,700 is still in your trading account, and $55,700 has been withdrawn for your business and personal use.
This gives a whole new meaning to the concept of compound rate-of-return. This is compound rate-of-return on steroids!
Keep in mind that, as your account balance increases, the size of your trades increases proportionally; this is how the power of compounding is harnessed to grow your account exponentially. When your $1,000 account has grown to $2,000, you will increase the size of each trade from 1 mini-lot to 2 mini-lots; and, when your account balance reaches $3,000, you will start trading 3 mini-lots on each trade; and so forth.
A 1% per day compound rate-of-growth in your account will double your account balance every 70 trading days (i.e., every 14 calendar weeks), and the size of your trades will double every 70 trading days, as well. Even as the size of your trades becomes very large, you will still be risking only 2% of your account balance on each trade.
The 10-pip breakout strategy used in the example above is just that ā an example. Any consistently profitable trading strategy can produce the rate-of-return described above, or more. In other words, any forex trader who is serious about achieving major success in this market can do so, using the trading style and strategy which best suits his or her temperament, time-availability, and risk tolerance.
Time for a Reality Check
You can play all sorts of games with the numbers shown above ā and maybe you did, as you were reading this.
āWhat if I donāt take any money out of my trading account, and let ALL my earnings compound?ā
āWhat if I start out with $5,000, or $10,000, or $20,000 instead?ā
You can make yourself a millionaire in a very short time ā in theory, on paper ā playing these games.
But, letās get real.
Letās go back to the beginning of this post. The wonderful numbers shown above are based on a big if ā
ā if you can earn a NET 110 pips every two weeks. Thatās 55 pips each week, NET after all losses, week after week, for three years. Can you do that? Can you trade that consistently? In other words, are you a trader?
If you canāt consistently earn 55 pips, or 20 pips, or 10 pips, every week, week after week, year after year, then you shouldnāt waste your time dreaming about hypothetical riches.
You should spend your time perfecting your methods, your timing, your money management, and your emotional control, until you become consistently profitable.
After you achieve that, there is no limit to how much you can earn.
Clint
But sureā¦ there is the possibility of tax somewhere down the line.
