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