Compounding, or not compounding rather, is why you can’t turn a profit. Compounding, the process of reinvesting gains over time to enhance total returns, is a term often used when talking about savings accounts and retirement investing. It is rarely heard in the halls of speculation but should be because it is the key to making those big gains you’ve been looking for.
If you are like me I know that you prefer trades move firmly into the money, make the max profit and return double or triple digit profits. The problem is that not all trades work out like that, most don’t, and holding out for the big money usually means risking small profits your account shows on paper. Going for the big money means taking big risks and big risks means big losses when those trade don’t work out.
However, if you were to take the small profits when you see them, let those profits build up and reinvest in them in your trading strategy you will see those big gains much sooner than you think. Your trades may not return 100% or 500% ROI like you’d like to see but they will start paying $100, $1000 and $5,000 a pop when your account is big enough.
What does this mean for you and your trading? Be satisfied with smaller profits. Let your account grow and stick to your money management rules. It may also means adding a new rule to your list, one that says always take profits when certain events occur. For me that means a profit near 100%, or any time I look at a trade and say “dam, that’s nice”, because when I don’t those opportunities tend to dry up.
My advice stops looking for the home runs, the full field goals and the easy money and focus on making small returns consistently. Let’s look at some numbers, shall we? Starting with an account of $1000 and assuming a 5% risk tolerance (not high and not low) and trading with no leverage (for simplicity’s sake) this means trades of $50. When that trade goes in the money you may make 25%, or 50% or even 100% just like you thought. If you let your excitement take control and wait for those profits to turn into 200% you could lose the whole trade, or at least end up with less profits than you originally thought.
If, instead, you sell when profits are at least 50% you’ll make at least $25 dollars. Adding up those $25 wins over the course of 10 trades your account will grow to $1,250 (assuming no losses of course) and your 5% risk per trade grows to $62.5 per trade. At this level a 50% profit grows to $31.25 which means 10 wins equals $312.50. When your account grows to $5,000 your trades will be $250 and your profit per trade $125, when your account grows to $10,000 your profit per trade will be $250. It will take some time to accomplish but if you focus on smaller profits and let them compound in your account you will be able to grow your account and make the big money.