These compounding techniques are the most powerful thing you can apply to your account

I’m not usually one for quoting poetry, but this one just encapsulates the most powerful thing you can apply to your trading …

Don’t you want that power at work on your account balance?

How to harness exponential growth

It’s dead easy to apply exponential growth to your trading by simply compounding your winnings. This means ploughing back your profits into your trading account.

So, if your account size on Monday was £1,000 and you risk 2% on each trade, your risk on Monday would be £20.

If by Tuesday morning, your balance is sitting at £1,050, then your 2% risk per trade becomes £21.

Simple compounding will also take into account your losses, so if your trading balance falls to £900, then your risk-per-trade at 2% becomes £18.

What can go wrong with compounding?

The effects of exponential growth can feel like magic when turned onto our finances, but there’s one thing that compounding hates – volatility.

I’ve written at length about volatility drag in the past (you can find a post here), so won’t dig into the intricacies of it now. But what’s crucial to understand is that bumpy returns with steep drawdowns will damage the effects of compounding.

So, smoothness is the key …

The 5 compounding techniques you should consider

There are some different techniques you can use to smooth out and dial up the effects of compounding. The right one for you will depend on your risk appetite and the strategy you’re using, but you should be applying at least one of these to your trading account right now (you can also combine them for a made-to-measure approach) …

1 • Simple compounding technique

Simple compounding is the technique described above, in which we reinvest all our winnings after every trade. In this scenario, risk per trade is calculated as a percentage of the balance on the account at the time of placing that trade, whether that balance has increased or decreased.

2 • Positive-only compounding technique

If you only include the winnings and don’t account for drawdowns when placing trades, you’ll could be able to recover more quickly from losses.

With this technique, if you’re trading at 2% risk on a £10k, your first trade will be risking £200. If that first trade loses, you’ll still calculate your risk-per-trade from the high of £10k, meaning that your actual balance on the account is £9,800, but you’ll still be risking £200.

This will mean that during a drawdown, your risk-per-trade will increase – be very cautious about this and ensure that you’re always comfortable with the risk levels you’re taking.

3 • Compounding less often technique

Applying compounding after every trade is the most aggressive approach, but not always the most successful. By waiting until the week … month … even year end, you can effectively ‘smooth’ out your profit curve and make compounding work harder for you. This can be very effective in strategies with highly volatile returns.

4 • Using a compounding throttle technique

This technique is another way to smooth your compounding progress. You’ll set a fixed amount that’s the maximum you’ll adjust your bank size by on any given time period.

So, let’s say you’re compounding monthly, risking 1% of your bank per trade and have a 10% throttle in place. You’ve had a great month and made 15% gains, growing your bank from £12,000 to £13,800. Your risk-per-trade last month would have been £120. But rather than increasing to £138 this month, instead it will only go up 10% to £132.

A throttle also allows you to build up a slush fund of your winnings, which you can choose to spend … or use in the fifth technique …

5 • Topping up losses technique

If you’re able to top up after losses, you’ll get all the benefits of compounding, without the downsides. But, of course, this will depend on how steep your drawdowns are and how deep your pockets are! This can be applied alongside throttling, where you can dip into that slush fund you’ve built up to deal with losses.

So, how fast will these compounding techniques work?

That poem at the beginning of the post was doubling every line … realistically, that’s not the kind of performance we can expect from any trading strategy. If you’re doubling your money on every trade … well, you’re not trading, you’re doing some high-risk gambling and it’s unlikely to end well for you.

So, exponential growth on your trading account won’t be at the thrilling, pulling-to-the-vertical level after just four trades. I’m sorry, but it’ll take a bit of patience. And that’s where so many people drop away from serious investing … the boring bit.

So, be realistic about the time it’ll take for you to hit that thrilling upward curve.

There’s a simple calculation that’ll give you an idea of how long you’ll be waiting – just divide 72 by your growth rate.

Let’s say you’re making 24% growth per year. To double your money would take 3 years. (72/24=3)

Or if you’re making 6% per month. To double your money would take 12 months.

(72/6=12)

(Bear in mind that this doesn’t account for volatility of returns – it assumes that you’re making exactly the same profit each month, which won’t be the case in real-world trading.)

Still frustrated in the boring flat bit? Here’s a tip …

One of the fastest ways to power through the “boring bit” is to use regular top-ups. These will seriously boost the effects of compounding. It doesn’t need to be a lot – but those small, regular additions will see the speed at which your wealth grows really pull towards the exponential. The chart below shows the growth of a £1,000 account over 20 years with a 20% pa return, compared to the same strategy, but adding £600 each year to your account.

And beyond that … be patient, get over the hump – the rewards will be worth it!

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