The Seven Rules of Magic Trade Compounding

In The Lure of Doubling your Money, I wrote about a fantastically profitable AREX trade that offered investors an opportunity to double their money in a single 4 month trade in late 2011.

The problem with this trade was that it was the only opportunity all year, in this stock to get a 100% return. Investors that spotted this beautiful rally and stayed in for the full 100% were very patient, very skilled, or very lucky.

I made a number of AREX trades in 2011, but wasn't one of the lucky traders who nailed the 100% gainer. And that made me pretty annoyed. So I've been looking at a better way to make 100% returns on your money in the same time frame, but without having to nail a single, big lucky trade that only occurs once a year. 

The 100% Six Month AREX Backtest
So what I did was backtest AREX using what I'm calling the 'Magic Trade Compounding'  starting with $5000, and using  swing trades under 15 day duration, based on a common set of technical analysis charting tools. I didn't refer to an index once, and used no news reports of the stock or the market. I completely ignored earnings and fundamental information.  During that seven months, the market was all over the place, and AREX ended the six months at a lower price that when it started.

Here's the result:

1/3/2011  Start Capital $4,688  (200 shares at $23.44)
23 trades later.... (less than one a week)

7/1/2011 End Capital  $10,418.00 (450 shares at $23.00)

122% Return in 7 months

The Seven Rules of Magic Trade Compounding
1. Choose a volatile stock with clear chart movements
2. Trade the same stock again and again
3. Use the same charts, indicators and rules every time you trade.
4. Reinvest the new account balance on every trade, whether you win or lose.
5. Make your trading decisions at the same time(s) every day
6. Never make a trading decision before 10:30 in the morning EST.
7. Decide how much profit or loss to take based, and automate trade exit.

The Magic of Trade Compounding

In The Lure of Doubling Your Money, I gave an example of a fantastically profitable trade on AREX that allowed savvy investors to double their money in only 45 trading days. The catch: you had to spot a key reversal in the stock, and also get in and out at exactly the right time. Difficult, stressful, perfect timing required. Does that describe what you want as a trader?

Lets look at another way to manage your money as a trader. What are the other ways to double your money? Lets say instead of trying to double your money in a single trade, you commit to making a lot of small trades, where your target is just to make 5% every time. Is it easier to find a opportunity to make 5% than 100%? Of course! Is it easier to make 5% again and again, than make 100%. Probably. But you will definitely get a lot more practice, learn a lot more, and risk less of your capital if you do it right.

The Magic of Trade Compounding
Trade compounding is where you strictly reinvest your entire profit from each trade in your next trade. The principle is exactly the same as the idea behind compound interest in a regular bank savings account, except for instead of the bank paying interest on a yearly basis and reinvesting it automatically, the profit from each trade is reinvested.

In this simplified example, we start with $5000 in our trading account, and make a series of profitable trades. Each trade makes a profit of 5% over a 3 day duration. The profit is reinvested each time, just as interest would be in a bank account. Each trade buys the amount of stock listed in the start balance column. You can see the end balance after 15 trades is $10,395, so we have doubled our starting capital in 45 trading days.


There are a couple of really important things to notice here. The total amount of profitable trades is only 75%, yet your capital gain was a little over 100%! So straight away, trade compounding gives you a 25% increase in profitability, when compare to attempting to pull off a single 'double your money' type of trade with a 100% gain.

Of course, a succession of real trades is never going to look like this. Sometimes you lose right? And the duration of trades is never the same.  So won't your trading log look a bit more like the table below?

Here, as well as trade compounding, a strict 3% stop has been introduced. We are going to compound all our trades by reinvesting the entire start balance on every new trade. But we are also acknowledging that roughly every third or fourth trade we will actually lose money. To limit the impact of the losing trades, we are going to apply strict discipline in the form of a stop. Our rule is that we  are going to limit losses by using stop orders on every single trade, based on around 3% loss.  Profitable trades we will let run to see how far they go. 


Again, there are a vital things notice in this table. At this point, this is still just a theoretical example. But it's looking a lot more realistic right?   While theorectical, the durations and percentage returns are quite realistic for small cap stocks which trade on the NASDAQ. There are thousands of stocks that have price movements over 1,2, 4, 10, 15 day duration, of between 3% and 20%. But stocks have 100% price increases are much harder to both find and predict.


Notice also that even though 4 from 15 trades were losing, the End Balance only dropped below the original start balance of $5000 once! Isn't that a lot better than the nightmarish 'buy and hold' rollercoaster described in the 'Lure of Doubling Your Money' article, where as a buy and hold investor, you saw your investment swing from 25% gain to a 39% loss, and your timing had to be perfect in order to bag the elusive 'double your money' trade?

You can also see that the losing trades, when a strict 3% stop is applied, the lost ends up being  just temporary setback to your ever growing capital.

So let's get real....how do we consistently make small 3 - 10% percent profits. The key is the next piece of magic - Trade what the Market is Doing, not Where You  Want it To Go

The Lure of Doubling your Money

Most traders dream about doubling their money trading. They read through investing newsletters that scream about 79%, 135%, and 250% winners. They scour company reports, and try and figure out which companies have the best possibilities of doubling their money.

But are they just wasting their time? Is looking for trades with 100% or more returns worthwhile, or more a matter of luck? Lets look at a real example of a possible 100% trade from 2011. This is a theoretical trade, but using real market data.

Doubling your Money on AREX
Let's say we have a hunch or get a great tip about AREX, an oil and gas stock listed on the NASDAQ. Let's say the tip was that because it had hit the years low, a reversal was likely.  We invest $5000 buying AREX stock at just at the right time at $16, just hours after it hit's the low.  We hold on all the way to the magic 100% gain at $32, where we sell during an aggressive pullback, where it drops nearly 8% in a single day. The duration is a fairly fast (for doubling your money) 45 trading days. This is real market data, so there are definitely investors out there who nailed this exact trade.

Our theoretical trading log might look something like this:

The question is, how many people actually spotted this trade? , How experienced would you need to to be to spot it? AREX started the year at $23.18, and ended the year at $29.89 If you had bought AREX at the start of the year as a buy and hold investor, you would have made at very decent 28%. However, for about half the year, you would have actually been in the red. At the worst point, when it dipped to $14.14, your original $5000 would have shrunk a whopping 39% to only $3050. That's a pretty big loss for most investors to stomach over 9 months of buy and hold.

AREX Weekly chart over the entire 2011

Looking at the weekly chart, you'll realize that in fact, this was the only opportunity in an entire year to make 100% trading AREX stock in a single trade. So you had have to have waited 6 months to spot this opportunity and commit your money. But are you really that patient, observant, or psychic?  Are you really that experienced?

Lets look at another way to both trade and manage your trading account, that lets you double your money without your account balance ever losing more that about 5%. I call it The Magic of Trade Compounding.

Swing Trading Strategy Example Day 1

1. Determine what the trend on the daily chart, based on color and trend of candles, EMA averages, MAC-D and RSI.  The easiest and clearest way to mark a trend is to simply draw a single line through the candles that mark that trend.

2. With most swing trades, we are trying to pick the point where the price turns around and goes in the other direction. This is because reversals tend to move the price more quickly in a short space of time than longer term trends.

Example: AREX 9/26/2011 - 1 day chart

Trend = strong down trend. 


The trend on this graph would normally signal a short trade, however RSI-7 is way down at 10, which indicates a very high probability of the trend turning around. The price has also penetrated the lower bollinger band in two successive candles, indicating there will be a strong tendancy to 'spring back' if the trend does not continue downwards. Going long in such an aggressive downtrend is a risky trade as if the downtrend continues, we'll be stopped out within a day or less.

4. Fill in the Plan section of the trading spreadsheet with the reason for the trade and the planned position. Our target is to make 3% per trading day, with this being a short fast bounce trade.

3. Determine how much to trade. It's best to stick with the same amount of shares in one stock, so you are comfortable with the win and stop lost amounts related to that amount. Only trade bigger positions when you are comfortable with you record with that amount.

5. Once you had decided to commit to the trade, determine the exact entry point based on the 5-minute chart. This is where patience comes in.

AREX 9/26/2011 5 minute chart.  This chart shows the entry point. The stock appears to have found support at $16 after the aggressive 5 day downtrend visible on the 1 day chart. Such an agressive downtrend is perfect conditions for a bounce to occur with the RSI so low.  We'll enter at 16.25, just as it starts to tick up and the EMA-8 flattened out then rapidly started to climb. Notice the MACD cross, which signals the start of an uptrend.

6. Fill in the Execute section of the trading spreadsheet with the exact trade entry price once the opening order has been filled. At this point the Last price is the entry price. The Income at Last Price show an $18 loss, which is the commission.

7. Now calculate the "Take Profit Price" and the "Stop Price" for this trade, and enter these into your broker as triggers to close the position automatically - both high (income) and low (expense).

The Take Profit Price is where we will sell the position regardless of what the stock is doing. This is take decision making out of the equation in the heat of the moment. Even if it is going up, we will sell this position at that price using an automated trigger to close the position. This is to ensure that gains are actually converted to cash. The other reason is to capture gains if the price spikes up to this price, even for only minutes while you are not there to hit the sell button. This price should be set at a level where you would be entirely happy just walking away with money in the bank, thinking "that was easy money".

The stop price is the amount that you are willing to lose if the trend does not do what you want. This is also automated using a stop market order. You want a stop market order, not a stop limit. If the stock dives fast and is thinly traded, you want to sell immediately to limit further losses. A stop limit order may not achieve this if your order cannot be filled.

For our AREX bounce trade, we are setting the Stop Price at $15.75, which would result in a loss (expense) of $168. Our Take Profit price is $18.25 which would result in an income of $582.

8. At the end of the trading day, update the Last Price in the spreadsheet based on the closing price for the day. Adjust your Take Profit Price and Stop Price if required.

Wow, our AREX bounce happened as intended! We made 5.97%, or $291 on $4875 capital in a single session.  To lock in some of this profit, we will raise the stop price to $16.90, which still gives the stock some room to move, but means our guaranteed profit for this trade will be $177, so we can relax. Our Take Profit Price will stay the same.

Here is the five minute chart to show how the day went. Our initial $15.75 stop price was not triggered, even though the stock did dip back down to $16.20 before climbing fast in the afternoon.

8. Day 2 Begins.  As we have an automated 'Take Profit Price, and the automated 'Stop Price' in place that will both make us money if triggered, there is no rush to be at your computer when the market opens. In fact, trading the open is something that is usually just not worth while unless you are specifically a day trader, and very experienced.  Trends are rarely visible, and if the market or a stock 'gaps up', the gap is often closed with the first 30minutes of trading, and the real trend for the day only comes obvious later.  I usually start looking to see what has happen at between 10:00 and 10:30 am. This is a good time to make decisions, and adjust Stop Price or Take Profit Price triggers based on where things appear to be heading.

Our AREX trade is spectactular! It gapped up to start trading at $17.8, then shot up and triggered our Take Profit price trigger within the first five minutes of trading. Our Take Profit trigger closed the position at $18.25 before we even had a change to check what the markets were doing. In other words, we started the day with real cash in our trading account, not just stocks at a higher value.   This trade took advantage of a highly volatile situation to make $582 profit on capital of $4,875, which is 11.9% gain within 24 hrs. A day trader would have missed much of this profit by closing out their position at the end of the day.   This trade way exceeded our expectations of 3% profit per trading day so we self-scored a perfect 10. The expense we were willing to occur in this risky trade was moderate at $168.

9. Fill in the Actual area of the trading worksheet to record the details of the trade


The 5 minute chart.

The 1 day chart

As you can see, in volatile market conditions of autumn 2011, combined with a volatile oil and gas stock like AREX, there were plenty of similar sized moves to this one.