Traders learn a lot about technical indicators, chart patterns, and trading strategies but don’t pay enough attention to basic points of the trading process.
For many traders, mostly beginners, trading is a process of investing money into one trade and withdrawing it in case of success. Not everyone thinks about reinvestments. What is it, how to calculate possible profits? Let’s figure it out and look at the example of compounding calculator.
Compounding: Meaning
Compounding is a kind of reinvestment. Reinvestment is a situation when you don’t withdraw your profit but put it into a successful trade. Profit for each subsequent period is measured based on the amount of the initial deposit and previous periods’ income.
The most common example is savings on your bank account. According to the agreed percent, every period, let’s say a month, the bank pays you an amount for using your funds. The sum of your savings increases, thus the bank’s payment rises every month.
The same scheme works in the stock market, where investors can compound dividends. In Forex, you can reinvest your profits. Let’s say you get interest on interest.
Compounding: Example
Let’s consider compounding on an example. Imagine you want to reinvest your profit four times during a year, thus each quarter.
- In the beginning, the Forex calculator will show your potential profit for three months from the initial deposit amount.
- In the second quarter, the profit amount is added to the initial deposit. Thus, the final profit is re-calculated on the new amount.
- In the third quarter, the calculator considers the profit of both previous quarters and adds it to the initial deposit.
- In the fourth quarter, you get a result based on the sum of the initial deposit and the income of three previous quarters.
As you can see, your income grows in geometric progression. Traders reinvest as there are odds of the exponential profit growth – you profit not only on your investment but also on the reinvested capital that raises the position’s volume. Without reinvestment, your potential profit is linear.
Compounding Calculator
Although trading is a hardly predictable activity, it’s better to know what income you can get in advance and whether you should risk your funds. But how to count the compounded income? There is a compounding calculator.
The compounding calculator allows traders to count the earnings based on the specified parameters such as initial deposit, monthly profitability, investment period, the number of investment periods.
Still not clear how it works? Let’s look deeper. The work of the calculator is based on the formula. To count your possible profit of the reinvestment, you should set the amount of the initial deposit, monthly profitability, and the number of times you want to reinvest.
- S – Future value that a trader will receive in the end
- D – Initial deposit
- r = Interest rate or the expected annual yield of trading. You can take this value from the historical data.
- n = the number of reinvestments within a period
- t = number of periods
Should You Reinvest?
We will consider two examples that clarify how the reinvestment strategy differs from the withdrawal strategy.
In this case, a trader doesn’t withdraw or deposit money.
Parameters:
- Initial deposit – $1000;
- Average profitability of the trading system is 5% per month;
- Investment period is six months;
- Final income = 1000 + 1000 * 0.05 * 6 = $1300. Potential profit equals to $300.
Compounding Strategy
In this case, a trader reinvests profit every month. Parameters are the same.
- First, we count the profit for the first month: $1000 + 5% = $1050.
- Profit for the second month: $1050 + 5% = $1102.5.
- Profit for the third month: $1102.5 + 5% = $1157.63.
- Profit is calculated similarly for the remaining three months.
- The final income is $1340.1. Thus, the profit is $340.1.
With the compounding calculator, the calculation is the same but is based on the compound interest formula:
S = 1000 * (1 + 0.3/6)^6 = $1340.1, where
- $1000 – initial deposit;
- 0.3 – interest rate. The entire investment period is six months, so the yield is 5% per month, r = 0.05*6;
- 6 – number of reinvestments;
- t = 1.
Summing Up
Nevertheless, if it was so simple, everyone would reinvest every time they traded and earned a fortune. Where are the pitfalls?
You should remember that the reinvestment strategy is not effective for every trade. If your strategy aims at long-term investments, you can reinvest. Still, you should understand that markets are highly volatile, and there are risks if your profitable trade turns negative soon. When trading with the constant withdrawal of at least up to an amount equal to the starting capital, you reduce risks. Reinvestment can be a tricky thing.
The forex calculator helps investors to understand how fast they will reach the desired profit and whether the risks are worth this income.
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