Fun With Numbers - The Joys Of Compounding

11/17/03 10:05:04 AM

by Matt Blackman

Ever wondered how much you would make in a year if you were able to sustain an average daily return?

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Position: N/A

We have all heard traders brag about how much they made last week or last month, whether it be from our circle of friends or in ads promoting trading and advisory services. But part of every trader's written plan should include realistic goals for what you expect to earn over the long haul. Here are the calculations to quickly find out how to convert daily returns into compounded annual profits.

Let's assume Jose is trading the S&P500 e-minis. He has a $10,000 futures account and starts by trading one contract (no more than 20% of his capital is at risk in any trade). An S&P500 e-mini contract is worth $1,800. He takes nothing out of the account other than commissions, which are $3.00 per contract per trade ($6.00/round trip). As his account grows, he increases the number of contracts traded equal to a 20% of his account size.

Jose has been trading the e-minis for two years and has gotten pretty good at it. His average is 3 points a day (I personally know people who do better than this). Assuming Jose averages four trades per day, trades five days a week, 40 weeks a year, here is what his account will be worth at the end of the year.

3 points = $150 - $24.00 (four round trip commissions) = $126.

$126/$10,000 = 1.26% per day. Let's say 1.0%

How much would Jose have in the account at the end of the year? By the end of the year, Jose would be trading 40.6 contracts. Since you can't trade fractional contracts, the total would be different as the account grew, so the total below is an approximation. The calculation is easy if you have a calculator that does exponentials. (To calculate the exact amount of profit, construct a spreadsheet and do each calculation with the correct number of contracts as the account grows.)

1.01²⁰⁰ = 7.316 X $10,000 = $73,160

You are probably saying the figure is unbelievable and I'll admit, it does sound rather far fetched. First of all, 1.0% per day times 200 should be worth somewhere around 200%, right? Wrong. That is the calculation for simple interest and does not take into account the power of compounding. Thanks to compounding Jose has made over 700%!

Still not convinced? Let's assume then that Jose only does 1 point per day in two round-trip trades.

1 point = $50 - $12 (commission) = $38
$38/$10,000 = 0.38% per day.

At the end of the year Jose would have:

1.0038²⁰⁰ = 2.135 X $10,000 = $21,352.00 in his account.

Doing a modest 1-point per day and reinvesting (or retrading) his profits, Jose has more than doubled his money in the year. Granted, working a year trading full time for $11,352 before taxes may not seem that attractive but if you were trading a $50,000 account for example, you would have made a profit of $56,750.

The moral of this story is that traders and investors often lose sight of how powerful compound interest is in helping grow accounts. A buy and hold investor (becoming an endangered species) may boast that his account has grown 20% in the last six months but he was invested and exposed to risk each and every day. A trader can do the same return in a month as opposed to six if his returns are compounded with each trade. The other benefit is that there is no risk while he is not in a trade.

So the next time someone asks you if you would rather have an account that earned 1% compound interest per day or 200% per year, you know what to tell them. Most people get it wrong.

Matt Blackman

Matt Blackman is a full-time technical and financial writer and trader. He produces corporate and financial newsletters, and assists clients in getting published in the mainstream media. He is the host of TradeSystemGuru.com. Matt has earned the Chartered Market Technician (CMT) designation. Find out what stocks and futures Matt is watching on Twitter at www.twitter.com/RatioTrade

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