Albert Einstein once said that compound interest was the eighth wonder of the world. Those that understand it, earn it, and those that don't, pay it.
Today's blog explores the compound interest and how, used correctly, it can have a major positive effect on your trading and on your equity growth.
What is compound interest?
Most of you have experienced the effects of compound interest in one shape or another and usually to the most detrimental of outcomes.
Consider this example: If you've ever failed to pay the balance of your credit card at the end of the month, the bank is going to charge you interest that will be added to your outstanding balance. If you don't pay the new balance the following month, you're going to be charged interest on the new balance. Your debt is going to increase every month and the bank is going to charge you interest on the interest, and this is known as compound interest.
Indeed this is the 8th wonder of the world, but for the banks, not for me and you. In the Forex market, you can benefit from the compound interest and it is the most efficient way to grow your account over sustained periods.
The fixed lot approach and the compound approach
For example, for a 1000$ betting account you have two approaches: the fixed lot approach or the compound approach.
Each bet on the fixed lot approach is 100$. Let's assume you are very lucky and have five winning trades on the bounds. So after you bet your first 100$, your account will be at 1100$. When you're going to win the 5th bet, you'll have 1500$ and a gain of 50%.
Using the compound interest approach with the same 100$ bet, your account will be at $1100 after the first win. The second bet takes 10% of the new balance, this means $110, so your account has grown to 1,210 bucks. After the 5th win, this account will be at 1,610$, which is a gain of 61%.
I wouldn't recommend putting 10% on each trade, especially for those who just start trading. But in this case, it makes sense.
It's obvious that using the compound approach, you can make more money and magnify your gains by an extra 11%.
To sum it up, it's obvious that using the compound approach, you can make more money and magnify your gains by an extra 11%. In Forex trading we're making our money work for us, so in profitable periods, we're increasing our betting size.
Let's analyze these two approaches in a losing period which is inevitable to happen.
Out of the $1000 we lose $100 after the first bet. After five losings, this account will be at $500 with 50% down. That's the fixed lot approach.
For the compound approach we're going to use a 10% bet on our $1000 starting balance. After the fifth bet in this cycle of five losing bets, your account will be down to 590, which is a drop of 41%.
How you should bet on each Forex trade?
In a losing period, your account is going to be protected using the compound approach and the loss will be smaller. Most beginners traders don't even look at this compound approach and go straight to betting a fixed lot size. Slowly but surely they'll bleed their account away.
The experienced traders who know how to grow an account will always look at the compound effect. You want your money to work better in the winning periods and protect in the losing periods.
I hope you have found this valuable. If you would like to learn more, join me in the Trading Room. I hope to see you there! Happy trading and good luck.