Tuesday, February 28, 2017

The power of compounding

When people trade Forex they often forget about the power of compounding. Some brokers even inadvertently make it difficult to get the benefit of this very powerful force, by insisting that all trade sizes have to be in ‘lots’ or ‘micro lots’. This means that position sizes can only be incremented in large amounts, so that compounding can only be done on long time scales, such as every month or so, if it can be done at all.

The compound interest formula is one of the simplest there is. To make it work, it is only necessary to know the starting amount (which we designate to be ‘P’, which stands for Principal), the number of compounding periods, which we call ‘t’, for time, and the interest rate to be applied on each occasion the amount is compounded. This means, for example, that if we compounded each week for a year, we would have 52 compounding periods, but if we compounded each month the number of periods would be 12. The interest rate in the first instance would be the profit rate achievable per week, and in the second case it would be rate we could reach every month.

Here is the formula (‘A’ is the amount we will arrive at when the compounding is complete):
In plain English: Amount equals principal, multiplied by one plus the rate, to the power of the number of compounding periods.

The more often compounding can be carried out, the more the effect will be seen. That is not all. Compounding also has a beneficial effect on the downside. On those occasions when a drawdown takes place in the account (and they will occur), our software reduces the amount of the position size using the same principle as when compounding on the upside. This has the effect of reducing the amount of drawdown during those periods when it happens. 

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