@forrestfield your compounding post touches on one of my favourite subjects when it comes to trading, because imo the power of compounding can take an ordinary return and turn it into an outstanding return if used correctly - and the beauty of it is, it doesn't require you to be a better trader - a compounding strategy as part of your money management can actually do the heavy lifting in terms of multiplying returns.
I will provide an example, which comes from one of my forex trading models.
This model involves trading only 2 setups on 6 currency pairs on an hourly timeframe. On average it generates just over 6 trades per day (about 1800 trades per year) and each trade lasts no more than 1 hour.
The average return per trade is only 7% of equity at risk and I risk 1% "of current equity balance" on any trade. In other words the average return is 7% x 1% = 0.07% of current equity balance. Let's say as an example my starting equity is $25K then 1% of equity at risk is $250 per trade, and the average return on all trades is 7% x $250 = $17.50 (net of trading costs: i.e. brokerage and spread, etc). While the average is $17.50, the wins will be several hundred dollars each and the losses can be up to -$250 (I always use a stoploss to cap the risk at the required level). So we are not really talking about a return worth posting on HC about!
However, the key phrase in the previous paragraph is the comment quoted underlined comment - risk is 1% "of current equity balance" - so what I risk on each trade is 1% of the current equity balance at the time I open a trade - this means I am compounding the returns after every trade, not daily or weekly or monthly - it is compounding on average 6 times per day.
Now of course some of those trades will be losses (this model has a strike rate of only 52% - but the average win is a return of 44% of current equity at risk (i.e. 44% x 1% of current equity balance), and the average loss is 33% of current equity at risk (i.e. 33% x 1% of current equity balance)) - but the net average return per trade is 7% of 1% of current equity balance. This is where compounding turns that average $17.50 win per trade into something much more...
Below is the equity curve of this model. It shows 3 curves actually, they are:
1. The yellow curve which is the un-compounded return. From an initial equity balance of $25K this becomes $63,244 in 12 months. This is a return of $63,244 - $25,000 = $38,244 = $38/244/$25,000 = a ROI of 152%. Not bad, but we can do better with compounding.
2. Now the 2nd equity curve (the grey one) shows the effect of standard compounding (after every trade). From the same $25K this curve becomes $112,253 in 12 months. This is a return of $112,253 - $25,000 = $87,253 = $87,253/$25,000 = a ROI of 349%. Now we are talking about generating the average yearly income from a $25,000 investment. But we can do still better...
3. The 3rd curve (the blue one) takes advantage of the fact that once we are in profit, we are playing with someone else's money. This means we can think about risking a little more than the 1% of current equity balance - on the basis that our trading model is performing fairly consistently. So this model involves increasing the compounding by applying the following rules:
Rule 1: The equity at risk is 1% of current equity up until we reach a 50% profit level on initial equity. In this example, that means up until we achieve an equity balance of $37,500.
Rule 2: Above the 1st profit threshold (50% profit level) we increase our risk exposure per trade from 1% of current equity to 1.5% of current equity. If the equity balance falls below the 50% profit level, we fall back to the 1% equity risk level, and if we return above the 50% profit level we kick back up to the 1.5% equity at risk level.
Rule 3: Above a 2nd profit threshold (100% profit level - which in this case is if we reach an equity balance of $50,000) we increase our risk exposure once more from 1.5% to 2% of current equity per trade. If we fall below the thresholds we reduce the risk exposure again, but if we go back up over them, we increase it, etc.
Now using this "accelerated compounding" approach we turn the initial equity of $25,000 into $282,016 in 12 months. This is a return of $282,016 - $25,000 = $257,016 = $257,016/$25,000 = 1028% ROI. Now we are talking about an executive level annual salary from a $25,000 investment.
And the beauty of the above is that this hasn't been achieved by becoming a gun multi-bag trader or by finding a higher probability or higher margin model - this is still a hum-drum but consistent low-margin model - where 90% of the return in the 3rd equity curve has been achieved not by trading the model itself, its been achieved purely by money management, i.e. by deciding to compound the returns.
Below the graph showing the equity curves are the 3 graphs showing the returns for every trade in the model according to the 3 different compounding strategies - they are the same trades in each graph, but the 2nd last and last graph show what happens to the value of each trade as the compounding effect kicks in - I have kept the scale on each of those last 3 graphs the same to show in relative terms how the trade values grow in size over time.
