The long-term goal of forex traders is to establish a solid structure or strategy that will ensure consistent profitability. There are several effective ways to build a steady trading structure for yourself, but one of the simplest is the forex compounding strategy.
With this strategy, even the smallest trading account can grow exponentially compared to an account that relies on regularly making the same investments for growth.
What is Forex Compounding Strategy?
When most people start trading, they begin with a modest account with the goal of making enormous returns very quickly. But in the forex market, one of the mistakes to avoid if you want to be a successful trader is expecting massive short-term returns because it only sometimes works out well.
This is why people promising 50% or 100% return on your investment never live up to their promises. This can work by utilizing aggressive trading strategies in the short term but will result in huge losses later on.
However, by taking a cautious approach and allowing compounding to work for you, you can generate long-term returns on your investment. So what is compounding?
Compounding requires reinvesting any interest earned back into the portfolio to increase the profits. In essence, it is a money management strategy, when combined with
trading indicators, that allows traders to increase their investment through accumulation and reinvestment of trading profits from previous trades.
For instance, if you start with a $1000 trading account with an interest of 6% every month, using a compounding strategy, your account will grow to a million dollars after 10 years. That is if you don’t top off your initial investment and rely solely on reinvesting the interest.
Compounding has a snowball effect. It starts small but continues to increase given time. The bigger the account gets, the bigger the returns. But there are other ways forex compounding benefits your portfolio.
Benefits of Forex Compounding Strategy
The effects of compounding are continuous. So, once you start compounding, the returns will continue even after the initial investment has been withdrawn. This way, traders are assured of long-term security and wealth creation because they know what sort of return to expect.
In addition, Forex compounding may offer some tax benefits. The gains made from trading can only be subject to taxes if they are withdrawn from the account rather than when they are earned. Therefore, by reinvesting the profits back into their portfolio, traders can enjoy tax deferments which allows them to keep more money in their trading account letting it accumulate over time and receive applicable tax benefits when withdrawing.
Plus, if the compounding dividends are taxed at all, they would be taxed at preferential rates based on the circumstances of the trader, which would boost performance.
In essence, forex compounding takes advantage of the simple financial principle of compounding combined with strategic investment decisions and management to generate good returns over a period of time. It is gradually becoming a popular trading method because it is a low-risk strategy that still maximizes profits. With compounding, the longer you hold your position, the more profitable your trading becomes.
Purpose of a Forex Compounding Calculator in a Compounding Strategy
Traders use several methods to determine a trading strategy’s profit/risk ratio. This allows you to understand the performance or efficiency of such a strategy and whether it is worth your risk. For Forex compounding, the Forex compounding calculator is one tool that helps traders answer these pressing questions.
The compounding calculator uses mathematical methods to accurately calculate the earnings of a trading portfolio based on specific parameters:
- Investment period
- Initial deposit
- The length of the investment period
- The monthly gain percentage
Benefits of using a Forex compounding calculator
Traders use a forex compounding calculator to calculate the interest over a specified investment period and the account balance at the end of the investment period. However, the calculator is also used to:
- Compare the aggressiveness or risk of different compounding strategies when using other instruments. This is why the compounding calculator is commonly used in creating high-risk strategies like pyramiding and the Martingale way.
- Calculate the initial capital needed to reach a certain profit target within a defined period of time. For instance, you can use the compounding calculator to determine the amount you need to make $5000 in a year with 10% monthly gains.
- Determine the interest rate of deposit growth and examine the profitability of your forex strategy with and without reinvestment of interest.
- Plan future money flow, set profit targets, and act as a performance indicator for trading systems.
The major downside of the Forex compounding calculator is that it may add the profit to the account balance only once a month which can be confusing for a beginner.
How it Works
The Forex compounding calculator is an easy way to estimate the performance of your trading account over a period of time. It helps you to calculate the following:
- The correct position volume is based on your trading strategy.
- The pip value is based on your preferred currency pair and position volume.
- Determine the risk level based on the leverage used.
- Calculate the expected profit according to the swap and spread in pips and currency units, along with the position volume of the specified currency pair.
- Determine the margin amount for the trade.
Luckily, many trading platforms come with a forex compounding calculator, and you do not have to pay to get a detailed overview of your trading future. Most calculators will require you to enter the following:
- The type of trading account you’re using
- Currency pair
- Leverage size
- Trade volume
- Exchange rate
- Starting balance
- Period of time denominated in years or months
- Compounding frequency, either monthly or yearly
- Percentage return
- Account base currency
The parameters could vary depending on the calculator you are using. Some may also include a monthly deposit or withdrawal before calculating the final results.
However, if you want to make the calculations manually, the rule of 72 is a simple way to achieve accurate results. Here’s an example. Assuming you get a 14 percent return on investment and there is assurance that the rate will stay consistent, your initial capital will double in 72/14 = 5 years.
You can also use it to calculate the interest rate if you know how frequently your investment will double. For instance, if you know your money will double every 6 years, the interest rate will be 72/6 = 12%. It is a simple formula that provides excellent insight when you start forex compounding.
Having Positive Net Pips
Forex compounding relies heavily on having positive pips, but it requires traders to not only have experience in the market and be successful at trading. To increase the success rate of your compounding account, it is essential to have a trading system with a success rate of 51% and above. This means that you must be successful from your entry point to exit more than half the time.
Focus on accuracy
However, having a high accuracy rate has some benefits regarding Forex compounding. For instance, if you have a 51% accuracy rate and positive net pips but end up suffering a string of failures consecutively, your prior winners will still give you a reasonable growth rate. Also, a higher success rate gives you more room to employ an aggressive trading technique.
If you succeed in achieving a 51% success rate, you can effectively use the leverage provided by the trading platform and make it work for you when trading with the most profitable currency pairs.
It is common knowledge that leverage is a double-edged sword because it drastically increases your profit and loss exposure, but it can be your best friend if you have the skills to use it. By combining leverage with forex compounding, you can increase your gains exponentially and shorten the time it would take for your capital to double.
But, it is still possible to successfully compound your account if you have less than a 51% success rate. In this case, instead of considering whether one trade is a success or not, consider the success rate of multiple trades and treat it as part of a sequence. From there, you can define a losing and winning sequence for your trading goals and enforce the definitions when trading.
Forex compounding is highly productive for beginners who have just stepped into the Forex market and are looking for ways to steadily grow their trading account. It is an ideal way to establish a dependable trading structure that will attract large-scale gains long term.
This method also reduces possible losses due to market volatility as well as the need to fund your account with outside sources. Although it is a powerful money management technique, it is important to take some time to master it in order to make the most out of it.