The Utility of Compounding on the Binary Options Market

09 Apr 2013, 08:00

There is no magic recipe that you can put in practice in order to ensure profitability on financial markets. There are indeed best practices that have helped other people and there are all sorts of theories. However, none of them can guarantee your success.

The popularity of the binary options market has led to the fact that every single day someone comes up with a new strategy which is advertised as risk free and bulletproof. There is no such thing, but you can still learn from experts and people who were or are successful on this market. Unfortunately, numerous players focus on their strategies and forget an essential point: money management. Controlling the risk and managing your account should be the starting point of successful trading. If you fail in doing these, no strategy can be profitable on the long run, no matter how good it might seem. There is one aspect which can be used in money management and which is often neglected: compounding.

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What Is Compounding?

This is a financial concept derived from mathematics which can be used in all investment strategies. It is perfect for the binary options market because this is a fast paced market and compounding accelerates the process of increasing profits even more. Compounding can help traders increase their returns while keeping their risks low in a very short period of time.

The concept of compounding was considered by Einstein the best mathematical discovery of all times and its opinion is highly trustable. Simply said, compounding helps you to make profits from your profits. It is the base which enables mutual funds and pension funds to be profitable.

An example can be relevant in understanding how compounding works. Let’s say you deposit $1000 and you place five trades, each of them of $100. This means that you use 10% of your account for each trade. Supposing that each trade wins, at the end of the week you will have $1350. In the next week, you can use all your money (the initial $1000 and the profit of $350) and place another five trades of $135. The value of each trade is higher, but the risk is the same because you only invest 10% of your account per trade. At the end of the week you’ll have a profit of approximately $475, if all five trades win. The example is of course hypothetical because in real life not all trades are winners. However, it helps you understand how compounding enables you to earn more without actually risking more.

The risk remained at 10% of your capital, but you were able to gain more in the second week. The profit depends on the number of trades you are placing and, obviously, on the number of winning trades. However, the idea is to generate a snowball effect and to eventually be able to win more by keeping risk under control.

How the Snowball Effect Works

As opposed to other strategies, compounding does not require you to use a fix amount for your trades. Instead, you will use a fix percentage of your account. In the above example this percentage was 10, but in real life it should be around 5. You establish a period of time in which you keep trading with the same percentage of your account. This can be a week if you are trading on short periods of time or a month. At the end of this time, you will notice that your profits are bigger than if you would have traded with a fixed amount. You can recalculate your funds and set another amount with which you continue to trade following the same principle.

Compounding enables you to increase your profits without necessarily taking higher risk. You can incorporate compounding in a long term strategy because your risks on the short term will remain the same.