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Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it”. When Uncle Ben told Peter Parker, “With great power comes great responsibility,” he meant that you have to control the power and use it for good. Similar is the case with the power of compounding. If you are on the right side (earning side) of compounding, you can make wealth from $10,000. But if you are on the wrong side (paying side) of it, your interest could spiral into a lifetime of debt.
What Is Compounding And How To Use It As A Trading Strategy?
What Is Compounding?
Compounding is earning interest on interest. It has a multiplier effect on your initial savings. The interest earned on the principal investment is reinvested and added to your principal. For instance, a 5% return on $10,000 gives you $500 in the first year. In the second year, a 5% return (compounded annually) is calculated on the inflated principal of $10,500, earning you interest of $525. The extra $25 is the multiplier effect of compounding compared to the simple interest of $500.
The compounding formula has two variables that significantly impact the outcome:
- Time invested
- Rate of Return
Among the two, the rate of return has a higher impact on the returns. Let’s look at this with the help of an example.
Formula of compounding: A = P [1 + ( R / N )] ^ NT
The above table shows that an investment with a 5% return took 10 years to achieve the $16,470 value. The investment with a 10% return reached a similar value in half the time (5 years).
Another interesting fact about compounding is that the first few years earn a little interest. It took seven years for the investment to double @ a 10% return rate. But it only took three years for it to grow by 70%. To harness the power of compounding, you need patience and discipline to stick to your investments.
Common Ways of Earning Compounding Interest
Now that you have seen the power of compounding interest, the next question is how to earn it. Many fixed income instruments allow interest reinvestment options. They have a fixed interest rate.
But when it comes to the stock market, there is no direct way to earn compounding interest as the returns fluctuate. A share might make you a 20% return in one year and a negative return in another if the stock market falls. For such stocks, the right metric is the compounded annual growth rate (CAGR). It is a geometric mean that looks at the end price and the start price of a stock in a particular duration and calculates returns considering earnings are reinvested yearly.
For instance, Constellation Software stock surged from $570.94 in September 2012 to $1,898 on September 22, surging at a CAGR of 12.76%. The stock has had some years of positive returns (40% in 2021) and some years of negative returns (-12% in 2022), but returns averaged 12.76% over the long term.
Dividend stocks can also give you the compounding effect through the dividend reinvestment plan (DRIP). For instance, BCE stock has a DRIP under which it reinvests the quarterly dividend amount in the stock. The DRIP compounds the number of shares and allows you to earn a higher dividend. You also benefit from dollar cost averaging as the reinvestment is quarterly. If the stock price falls, DRIP can buy more shares.
How To Use Compounding in Trading
Trading has high failure rates as investors take significant risks to make huge returns in the short term. Some trades can give you considerable capital gain, while some can make you lose it all. So if you are making a consistent 5% average return in a month, that alone can make you wealthy enough to retire in 10-15 years.
Here is a trading strategy that can help you compound your returns if you take a long-term approach and remain disciplined with this strategy.
Every trade has three components, trade size, target price, and stop loss. For compounding, you should use these components in the following manner:
- Trade size is the number of stocks or contracts (in the case of options) in a trade. To determine your trade size, you can use the formula (Trade size = dollar amount of risk/ (share price x stop lose percentage).
- Stop loss is the risk you take on the trade. The recommended risk rate is 1% and a maximum of 2% of your trading portfolio size. If your trading portfolio size is $10,000, your total risk should be $100.
- Target price is the reward you expect on the trade. To enjoy compounding, you should have a risk/reward ratio of 1:2. If you took a 10% stop loss, your target return should be 20%.
How To Trade for Compounding Return
Going by the above metrics, a trade will look as follows.
You have a $10,000 trading portfolio. You want to buy a stock worth $20 with a stop loss of 10%. The ideal risk percentage should be 1% (or $100) per trade.
Position size = $100/$20 x 10%
= 50 shares
For the above stock, you buy 50 shares at $20/share for $1,000, with a stop loss of $18 and a target price of $24.
If the trade is a success, you earn $200 ($4 x 50 shares), and your trading balance grows to $10,200. The next trade would have a risk size of $102 (1% of $10,200). It reinvests your $200 gain as your risk-taking amount has increased by $2.
Trade 2: Your trading portfolio grew to $10,200. Now you want to buy a stock worth $20 with a 10% stop loss.
Position Size = $102/($20 x 10%)
= 51 shares
For the above stock, you buy 51 shares for $1,020, with a stop loss of $18 and a target price of $24. This trade also is a success, and you earn $204 for the risk of losing $102. Now your portfolio is $10,404.
But not every day is Christmas. At times stop loss is triggered, reducing your investment balance. Considering you have a 50% success rate, a 1:2 risk-reward ratio with a 1% account risk can compound your returns.
Trading Risks Could Put You on the Wrong Side of Compounding
No strategy is full-proof. The above strategy can only succeed if your success rate is at least 50%. It could become worst if you take debt for trading, as it could compound your interest payment when your trade fails. You will land on the wrong side of compounding with leverage trading.
Initially, most of your trades might trigger a stop loss, or you might get lucky with a few trades followed by a series of losses. The objective is to take a long-term view of trading, analyze every trade, and build your knowledge. It is not about making several trades; but about making the right trades. Traders are using the current market downturn to earn from short positions.
You can use multiple strategies – trading for compounding, investing long-term in growth stocks, and DRIP – to make the most of the power of compounding in the stock market. Make sure you manage risk well and remain disciplined in your approach.
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