Compound interest is making riches since the dawn of time. A common problem is the waiting time. It usually takes many years before one start seeing the effects of it, so how do we fasten the process in trading?
When trading, the most common approach is to risk 1, 2 or another fixed amount of percentage for every trade. This way, when account grows, the position size will grow too! However, a 10% growth for the account, will grow the position by the same 10%, meaning if we risked $100 and won, then on the next trade we will risk $110.
This is not ideal as it will take a large amount of time for the account to experience the exponential growth. One sure way of growth could be the usage of leverage, but this, however, will increase the drawdown significantly. Let’s perform a simple Monte Carlo simulation with a 50% win rate and a 1:2 Risk Reward ratio for 50 trades when risking 2% for each. See Fig. 2. Please note that we have modelled some fees in, too- 5% from the initial risk.
The average return is 59% with the max drawdown of 10%. With the usage of leverage (2x) and the same parameters, the simulation spits out the average return of 142% and a max drawdown of 19%. Effectively- tripling the return but only doubling the drawdown. See Fig. 3
In the figure 4, we did the same simulation, but with different win rates having the same 1:2 risk reward ratio, risking 2% each time.
However, this is a classical approach. The one I have stumbled myself across is to increase the position size after each winner, using the winners’ profit, or half of it. Let’s do the same simulation as with a classical approach, but this time, whenever trade is a winner, to the 2% risk, I will add 50% of the profit from the last trade.
Difference is clearly visible. While the drawdown is increased and at lower win rates such as around 40% it does not make sense to use such approach- when the win rate increases, the compounding effect kicks in and soon the numbers become massive. The secret here is having consecutive winners- 3-4 now and then you will grow the account balance quickly. But since the risk increases together with the position size- the larger the winners’ streak, the larger will be the loss.
This is where the drawdown comes from, therefore we shouldn’t really be scared of the increased drawdown. It comes after the largest winners! And even yet, they are not that big, when compared to the overall chart. See below at the Fig. 6
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