A compounding strategy helps traders grow their portfolios and capital exponentially. Using the compounding strategy in commodities trading harnesses the power of compounding and can help traders significantly increase their corpus.
They can be suitable for short-term and long-term trades. However, it is essential to manage risk to make the most of this strategy effectively. In this article, we will explore what compounding is, how the compounding strategy works, and how to mitigate risk.
To understand the compounding strategy for commodities better, let’s first understand what compounding is.
Compounding, or compound interest, refers to the reinvestment of returns or interest earned on your investment. The reinvested amount becomes a part of the capital that you invest.
The power of compounding in trading is beneficial since the reinvested returns can help a trader significantly grow their capital. Further, the increased capital can generate higher returns, which are reinvested again. This creates a chain reaction and can considerably increase your invested capital.
Reinvesting profits instead of withdrawing them can amplify capital growth and potentially increase returns.
Let’s look at an example to understand compounding better.
A trader has invested ₹1,000 and is consistently generating 10% returns per month. Here’s how his capital would grow with and without compounding:
Month |
With Compounding |
Without Compounding |
||
Capital |
Returns |
Capital |
Returns |
|
1 |
₹1,000 |
₹100 |
₹1,000 |
₹100 |
2 |
₹1,100 |
₹110 |
₹1,000 |
₹100 |
3 |
₹1,210 |
₹121 |
₹1,000 |
₹100 |
4 |
₹1,331 |
₹133 |
₹1,000 |
₹100 |
5 |
₹1,464 |
₹146 |
₹1,000 |
₹100 |
6 |
₹1,610 |
₹161 |
₹1,000 |
₹100 |
7 |
₹1,771 |
₹177 |
₹1,000 |
₹100 |
8 |
₹1,948 |
₹194 |
₹1,000 |
₹100 |
9 |
₹2,143 |
₹214 |
₹1,000 |
₹100 |
10 |
₹2,357 |
₹235 |
₹1,000 |
₹100 |
11 |
₹2,853 |
₹285 |
₹1,000 |
₹100 |
12 |
₹3,138 |
₹313 |
₹1,000 |
₹100 |
Total |
₹3,138 |
₹2,138 |
₹1,000 |
₹1,200 |
The above example shows that a trader can benefit considerably through compounding by reinvesting the monthly returns. With compounding, the capital grew from ₹1,000 to ₹3,138, yielding a total return of ₹2,138 in 12 months. Meanwhile, if the trader had opted for simple interest, the invested capital would have remained the same at ₹1,000, with the total returns generated at ₹1,200.
Now that we’ve understood how compounding can help, let’s look at how one can use the compounding strategy for commodity trading.
Compounding strategies can further be classified into short term and long term strategies -
Compounding in Intraday: In this compounding strategy, you reinvest smaller profits on a daily basis.
Compounding in Swing Trading: Under this strategy, you reinvest the profits from one swing trade and compound your gains over several weeks.
Compounding with Scalping: It refers to quick and frequent trades to capture small profits. These profits are then reinvested in a controlled manner.
Trend Following Strategy: The trader holds a position for several months while compounding the gains.
Hedging Strategy: Profits from one position can be utilised to diversify risk and hedge positions through instruments like futures contracts.
Positional Strategy: In this strategy, the trader holds a position for a long period and reinvests the gains to benefit from compounding.
Compounding profits in commodities can help a trader significantly grow their capital. However, just like any other strategy, following strong risk management principles is of utmost importance.
Importance of Risk Management
While following a compounding strategy in commodity trading, it is crucial to have risk management principles in place to prevent capital erosion. As your capital grows, the importance of risk management is critical given the volatile nature of commodity prices.
Utilising Stop-Loss Orders
Stop-loss orders are one of the most important aspects of managing risk in any trading strategy. Every trade or strategy has the potential to fail, and a stop-loss order can help limit the losses. Traders can also use a trailing stop-loss in winning trades to book a portion of the profits if the price reverses.
Favourable Risk-Reward Ratios
To successfully and sustainably compound profits in commodities, it is important for a trader to enter into trades with a favourable risk-reward ratio. Maintaining a favourable risk-reward ratio can help a trader enter into trades with a high winning probability while minimising the risk and losses in the trade.
Utilising Leverage
Although leverage can come in handy and help generate substantial profits, it can also result in equally significant losses. A trader should exercise caution while using leverage, especially when their capital and position sizing increases. Moreover, a trader should also take on a position size that fits within their risk-taking capacity.
There are numerous benefits of compounding in commodity trading such as:
A compounding strategy in commodities can be suitable for both traders and investors. Trading in commodities can be risky. However, compounding can help one grow their capital without adding any additional funds. To make the most of the compounding strategy, one needs to manage risk effectively and consistently. A trader can exponentially grow their capital by sticking to a system and reinvesting their profits.
Compounding is highly beneficial in the long-term, and one should be patient to see the true power of compounding in trading.
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