The Forex compounding strategy is a simple yet effective way to grow your Forex portfolio, no matter what strategy you choose to use while trading. As a Forex trader, the main objective is to make a consistent and stable structure that brings good returns on investments. Compounding is a growth process. If you are familiar with the "snowball effect", you already know how something can build on its own. The compound interest is the interest earned on money that was previously earned as interest. This cycle leads to an increase in interest and account balances at an increasing rate, sometimes called exponential growth.
To understand compound interest, let`s start with simple interest: you place money and the bank pays you interest on your deposit.
For example, if you earn 5% per annum, a $1000 deposit will bring you $50 in a year. What will happen next year? Now we got to the compounding. You will earn interest on your initial deposit, and you will earn interest on the interest you have just earned.
So, the interest that you will earn in the second year will be more than the year before, because your account balance is $1050, not $1000. This way, even if you have not made any deposits, your earnings will accelerate.
Year One: With an initial deposit of $1000 you will earn 5%, or $50, bringing your balance to $1050.
Year Two: Your $1050 earns 5%, or $52.5; your balance is now $1102.5.
Year Three: Your $1102.5 balance earns 5%, or $55.13; your balance is now $1157.63.
Now applying that to Forex, the compounding is the method that is best suited to trading strategies that can take positive pips over time, regardless of the size of the position you place on the trade. For example, if all your trades were 1 standard lot over time, you would end up being profitable over the trading period. If you need to change your position to compensate for other losses, it means that you may be financially profitable, but you will not be profitable when it comes to measuring your total profit in pips.
Why does interest matter to Forex trader?
The interest rate is the basis for trading in the Forex market. The interest rate of a currency determines the perceived value of that currency. If the interest rate of a currency is high, then the value is accordingly high compared to other currencies that may have a low-interest rate. Every Forex trader must be aware of the central bank's monetary policy regarding the currency traded in the Forex market in order to know at what value to buy and sell securities. Given factors such as the starting capital and the currency traded, a trader can use the Forex calculator to find out the interest income from each trade.
Starting balance is very important when calculating interest from monthly trading. It is an element that the Forex Compounding calculator is working on in order to identify results that show interest in the monthly earnings of a trader. Please note that trading with a small starting balance is not recommended in some cases. This does not mean that a trader cannot trade with a small amount of money (if this is what a trader can afford to trade with), but if a one can afford more, then it is advisable to do so.
How do you calculate compounding interest?
You can calculate compound interest in several ways to get an idea of how you can achieve your goals and help you maintain realistic expectations. Whenever you do the calculations, consider several "what-if" scripts using different numbers, and see what happens if you save a little more or earn interest for several years longer.
Online calculators work best because they do all the calculations for you and can easily create charts and tables year after year. But many people prefer to look at numbers in more detail by doing their own calculations. You can use a financial calculator that has storage functions, especially for formulas, or a regular calculator if it has the key to calculate exponents.
To calculate compound interest, use the following formula:
A = P (1 + [ r / n]) ^ nt
To use this calculation, substitute in the variables below:
A: The amount you are expecting to have
P: original capital, known as the principal
r: the annual interest rate, recorded in decimal format
n: the number of compounding periods per year (for instance, monthly is 12 and weekly is 52)
t: the amount of time (in years) that your capital will be compounding
Example: You have $5,000 earning 10% compounded monthly. How much will you own in 10 years?
A = P (1 + [r / n]) ^ nt
A = 5000 (1 + [0.1 / 12]) ^ (12 * 10)
A = 5000 (1.00833) ^ (120)
A = 5000 (2.70596)
A = 13529.80
In 10 years, you’d have approximately $13,529. Your final amount may vary because of rounding. Out of that capital, $5,000 signifies your starting capital and the other $8,529 is that very compounding interest.
Importance of a Forex compounding calculator
The Forex compounding calculator is extremely valuable in every financial market. Here are several reasons why it is so.
It gives the trader an understanding of his net savings. Acknowledging that can boost a trader to either advance his current trading approach or make adjustments to deliver better results.
The ability to calculate the interest that can be achieved from a trader's initial deposit is one thing that can unquestionably bring many traders. It can help traders to stay away from losing positions.
As per statistics, only 10% of Forex traders make a sustainable profit and work full-time as expert Forex traders. These 10% positively implement all the trading tools possible such as compounding Forex calculators - something that can stimulate beginners to keep up trading and improving their trading approaches.
Here is a small example to illustrate the power of compounded money management. It's just an example, not a recommended strategy. Imagine that you have a $1000 trading account. You risk every dollar in your account. You make ten winning trades in a row, and with each trade, you exit for a double risk profit. How much money do you have at the end of these ten winning trades in a row? You will have $102,400, which is a percentage return of 1024% of your initial investment! Before you get too excited, think about the fact that your chances of ten consecutive winning trades with two to one chance are approximately 1 in 169,000.
A more valuable and real-world example of compounding power goes like this. Let's say there are 10 trades in which the profit is 0.20% on each trade with each time the risk of 1% of the capital - a very good result for any trader. Thanks to the continuous positive compounding, this trader ends a series of trades with a total profit of 4.62%.
Now imagine another series of 10 trades, where 0.20% on average per trade, but all profit comes to the final trade after 9 consecutive losses. Due to the continuous formation of negative values, the trader falls by -8.65% after the first 9 losing trades. Then the final trade is a huge winner, coming with a positive price to risk ratio of 11 to 1! However, at the end of the day, this second trader has a total profit of 1.40%.
Now you can understand why a higher winning rate can be so beneficial to the total profit, you can understand why stop losses can be very useful when used properly - to prevent catastrophic losing trades.
Summary
Wrapping up all the above mentioned, a compounding Forex strategy is a technique that helps you manage the money you've earned. This technique allows you to take the money you have earned in your profits and make better investments, increasing your income statistics faster than making the same sets of trades over time. The capital of your trading account will soar through the roof using the compounding method. This takes time, skills and effort to master the technique of increasing your income. If you learn and understand this technique, you are on your way to a better living.
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