Knowing and understanding your real rate of return on your FOREX trading is critical to your long term success.

Primary to this is that your rate of return combined with your overall win to loss ratio gives you a clear picture of your trading methodology's viability. Your trading rate of return as a function of wins to losses can be used as a mathematical view of your trading efficiency.

In addition, using the correct rate of return calculation enables you to have far more confidence in your over all trading methodology as outlined in your trading plan. When the negative runs hit, you'll have the confidence that in the long run your returns should be as expected with no surprises.

Thus, it's very important that you are calculating the correct rate of return to correlate with your win to loss ratio.

Of note is that to this post, I have a companion video of the same title: FOREX Trading Rates of Return Calculations that puts all of this together from a different view point.

If you've come from watching that video, then press on here. However, if this is your starting point, I might suggest that you read through this before watching the video. Or, if you want, you can skip to the bottom of this post to watch that video now.

Let's look at something you're maybe more familiar with, real estate, to demonstrate this issue.

You buy a house for $100,000, putting up $10,000 as your down payment. 2 years goes by, and you sell the building for $110,000. What's your return?

The immediate answer is that you made 10% because the building went up in value $10,000 which is 10% more than the original purchase price of $100,000.

But that's not exactly correct....

The building may have appreciated by 10% over that 2 years, but because you only put up $10,000 in your down payment, your return is actually 100%!

But that's your 'return'; it's not your 'rate of return'.

What?

Because you held the building for 2 years, the building appreciated 5%, $5,000, per year, and your rate of return is thus 50% a year. That's sort of like the APR (Annual Percentage Rate) that you pay on your credit cards but applied as a gain as opposed to an expense.

But hold on a minute.... if the building is appreciating 5% a year, then the first year it would be worth $105,000, right? So, after 2 years that makes the building worth not $5,000 more but 5% of $105,000 which is $5,250 for a total building value of $110,250, $250 more because of the compounding.

Because you sold the building for $110,000 and not $110,250, the building did not appreciate by 5% a year. The building actually compounded in value about 4.88% annually, i.e. the building's rate of return....

What about your rate of return then? Just short of 41.44% per year compounded.

But wait....

The building's value increased each year as the underlying asset, but did your down payment increase in value annually?

No. Your down payment was a static amount that you used to purchase the building. It only manifested its value upon sale of the building. So, magically almost, your $10,000 became worth $20,000 only because the value of the building increased. Thus, your $10,000 investment increased 50% per year on what's called simple annual interest, or rate of return.

And the answer is: you made a 50% annual simple return on an asset that had a compounded return at a yearly rate of 4.88%.

Let's take this example and map it into a currency trade.

In the real estate example, you bought a $100,000 building by putting up a down payment of $10,000. In a currency trade, you 'buy' or 'sell' $100,000 of currency by putting up some amount of money, i.e. the money in your bank. Best practices indicate that to trade 1 full lot of currency you should have $10,000 in your bank to trade which gives you $10 per pip returns.

So, let's say that over the course of the same 2 year period, your $10,000 bank has grown to $20,000. Can we make the same final statement as in the real estate example of: "you made a 50% annual simple return on an asset that had a compounded return at a yearly rate of 4.88%."?

No.

First off is that you needed to make many, many trades with that $10,000 bank in order to double your account. Well, I guess you could have sat there with one position for 2 years that went 1,000 pips in your favor, but let's put that aside as not reasonable. You made many trades.

Because you made many trades, the 'value' of the underlying 'asset', i.e. the $100,000 trade transaction is phantom. It doesn't exist because there is nothing that's traded other than price. And price in a currency trade is just a buyer and a seller who agree to make a trade.

Each side either puts up, or it cashes out their $10,000 bank to create the position. Without each participant, there is no 'position' to buy or sell....

The Schrödinger Equation

Postulated in 1925 by Erwin Schrödinger, a noted theoretical physicist and scholar who was awarded the 1933 Nobel Prize in Physics, this equation accurately defines the state of a system at each spatial position, and time, i.e. it gives the probability of finding a particle at a certain position.

Gad. What's this got to do with rate of return calculations?

Stay with me just a bit....

It turns out that the Schrödinger Equation defines something that really isn't — it defines a probability of something. Further confusing, but relevant, is that if you square that function — which means you're squaring an imaginary probability — you get a real probabilistic answer, i.e. some—thing concrete. Sort of....

A currency trade — if you really, really stretch this out — could then be that 'thing' that comes about through the combination of a seller of nothing coming together with a buyer of nothing to create 'something': a currency trade at some price.

Why bring Schrödinger into this? Well, because physics describes things mathematically for us that we might not otherwise understand well enough to take the next step which is to put to use the thing that was previously unknown or understood. In the case of the Schrödinger Equation we eventually were able to discover and use semiconductors, spectroscopy, materials research, and a whole host of other technologies that we would otherwise not become aware of.

But it's more than that.

At the core of it all: where did we come from? All we can say is from 'nothing' because we can't conceive of the root beyond where in the first stage of chemical evolution molecules in the primitive environment formed simple organic substances, such as amino acids. Before that: what?

If there are 300,000 EUR/USD sellers, but no buyers then there's no price; no trade. All of a sudden, someone decides to buy, which creates a transaction that we describe as price action.

All of whatever went on before that was probabilistic analysis; there was nothing. Now there's something that's been created from a couple of nothings. That's it.

So... how do you make any money then?

A trade is created by your buy/sell which must be based on your $10,000 margin plus trading capital — which I'll just refer to as your 'bank'. Because that event, i.e. the trade order fulfillment, is based on the price of that transaction, then it's your bank that becomes the 'real' asset in all of this.

This means then that you can choose to either compound your bank, or trade that static bank for simple returns.

Of course I know you understand the difference between compounding your account, or not compounding your account. However, I need to make sure both the distinction and the results between compounded returns, and what I'll refer to as 'static' bank returns are clear. If you don't really understand this differential in how your rate of return is calculated, then you could be at risk for a big surprise.

1. Compounding Only For Gains
2. Compounding For Gains and Losses (at 2% less of last trade)
3. No Compounding

The following calculations are all based on a starting bank balance of $10,000, winning 5% each month for 10 months, and then losing 8% for those 6 statistically likely trades in a row.

Compounded vs Static rates of return analysis

You can obviously see from the top 2 compounding examples that by reducing your position size by 2% in the second diagram that methodology is markedly better by $1,076.50 than not reducing position size as was the case in the first diagram.

The bottom diagram shows the results for not compounding for either gains or losses. As you can see by doing this, the results are $753.38 less in the account than by bi-directional compounding. That's a significant loss differential.

Of other interest is that both compounding examples show a $16,288.95 for the first 10 winning trades, whereas when you don't compound in the third diagram the balance is only $15,000, a rather significant $1,288.95, 13% negative difference over compounding.

Thus, compounding is touted by all educational resources as 'best practices', and the methodology to use when trying to build your account.

Well, if that's the case then why do the results from a major FOREX broker's analysis of 43,000,000 million of their client transactions reveal that 90% of traders lose 90% of their account in 90 days? Why is that?

I'm sorry, but I've followed all the so-called 'best practices', and most — including this issue of compounding — are simply not practical for even intermediate level retail traders. And I'm not sure most of them are all that viable anyway....

But that's just me being cynical, right? Yes. I got my ass handed to me by following these 'best practices', but also — of course, and admittedly ‐ by doing stupid shit. Mostly that stupid shit involved continuing trading my original lot size even after hitting those statistically probable 6 losses in a row pretty much right at the beginning, and by using 'best practices' risk to reward ratio garbage.

Howwwwwwwww-ever: Because of my background in physics, mathematics, and computer simulation analysis, I went back and looked in depth at all of these 'best practices'.

I re-thought the whole currency trading thing, and I back-analyzed all of that with my 40 years of real estate investment.

Let's see: I retired because of my real estate investing, and yet I became a Valued Member of the 90/90/90 Club trading currencies. After my analysis, I stepped back from everything, and literally in 15 minutes saw exactly what was wrong with most of the trading information available. I worked with my new plan for a couple of weeks, and then ran my remaining $5,000 to almost $10,000 in under 6 months.

Hummmm.... As Sherlock Holmes put it: "When you have eliminated the impossible, whatever remains, however improbable, must be the truth."

The 'impossible' here are all of the touted 'best practices'. Why else would 90% of traders lose 90% of their money in 90 days? Why?

So, to answer "To Compound Or Not To Compound: That Is The Question...." is simply: No. I should not, I do not, and I will not compound.

And why am I advising that you do not compound?

First of all:

I...am...

not...

advising...

ANYONE...

to...not compound.

What I said was: "I should not, I do not, and I will not compound."

Note the emphasis on I, as in me — I do not compound.

You do whatever it is that you need to do.

Even though compounding provides better gains, and reduces losses when done properly, I don't compound simply because each trade requires calculating a different lot size, as well as a host of other decisions that need to be made. Even if I wasn't a short term trader, I wouldn't compound.

In my opinion, doing this sort of thing is distracting, and fragments my attention to the actual underlying price action. It changes my focus from trading to the mechanics of trading. I believe, for me, this detracts just a little from any 'edge' that I may have.

I keep my trading very, very simple so all I have to do is focus on price action, and not get distracted by the mechanics.

• Compounding
• Simple Returns

However, the larger issues is: what value do you use to calculate a return against?

There are 5 possibilities:

• Total Account Size
• Full Lot Best Practices Amount
• Funds Available
• Margin Amount Only
• Funds Available Above Margin

Let's cover each one, again assuming a pair value of $100,000, trading 1 full lot, with U.S. margin requirements of 5% current price, i.e. in this example: $5,000. Let's further say that although you will only be trading 1 full lot, you have $30,000 in your trading account, and that you'll only do 1 transaction for the month, and that transaction results in a $1,000 gain.

And again, rate of return calculations in currency trading (as in real estate, etc) are not based on the value of the underlying asset, but rather the amount of money the investor puts into the transaction.

I'm further only going to do the calculations using the simple return method, and leave compound calculations for you to do if interested. It's just easier to describe and envision simple return calculations than some of the other issues that compounding has.

R = $1,000 / $30,000
R = 3.33% for the month, 40% annualized (i.e. 3.33 x 12 months)

This is how a hedge fund, or large institution must report their earnings - actually, they must report in terms of compounding or the whole concept of fund returns makes no sense.

Of course, the hopefully obvious issue arises here: What if you had $1,000,000 in your account? Would your monthly return then be 0.1% with an annualized return of 1.2%?

That would be silly, right? That's what the banks have to do, but if you did it that way, would it really reflect a true performance of your trading?

Hardly....

Because you have a $30,000 account size you could trade 3 full lots under those best practices guidelines — and that would be fine. Because you are only trading 1 full lot, however, the real 'value' of your investment is not your full $30,000 account, but rather just the suggested 'best practices' $10,000 for the 1 full lot that you're going to trade.

Okay, so let's run your return calculation again:

R = $1,000 / $10,000
R = 10% for the month, 100% annualized

Wow! With the magic of mathematics, you just increased your performance 67%! And you didn't have to do a thing different.

But, isn't that a better representation of the trading you did against the money you put at risk?

Sure it is!

Oooops.... But there are several issues with that....

R = $1,000 / $8,000
R = 12.5% for the month, 150% annualized

That's even better bragging rights, isn't it?

But, it gets even better than that....

No. All you really need is just enough to put the position on, i.e. your margin requirement of $5,000.

R = $1,000 / $5,000
R = 20% for the month, 240% annualized

Yikes? Really? Yes. Really.

But, it gets even better than that....

So, now, the question becomes: how much above margin do you need? $20, maybe $200?

Let's say that you have that $8,000 in your account. That gives you $3,000 above margin that you actually do use in the trade.

In fact: do you even need to consider your margin at all?

No, you could propose that you could not trade if you only had like $10 below margin, i.e. something like $4,990. You're actual trading isn't done with the margin, but rather money in excess of margin: $3,000.

R = $1,000 / $3,000
R = 33% for the month, 396% annualized

You could even go so far as trading 1 full lot on a $6,000 account, thus reducing your actual trading funds to $1,000 which results in the fanciful:

R = $1,000 / $1,000
R = 100% for the month, 1,200% annualized

For me, I use the best practices full lot account size of $10,000, or $1,000 to trade 1 mini, as the value I divide into any gain or loss on a per closed position basis.

For example, look at the following series of transactions:

As you can see, there were 2 Buy transactions that made up this position, each using $10,000 full lot bank for each trade; $20,000 total used for the entire position.

The position was closed with 20 pips profit on the first lot, and 15 pips profit on the 2nd lot, 35 pips, or a $350 profit on the position which is 1.75% gain on the $20,000 used in the trade.

I have more columns than that on my report, but that's the thrust of it.

At the end of the month, I take the total lots traded (simply adding up all of the lots used when each position is closed), divide that by the number of total transactions to get the average lot size, and then divide that into the total P/L for the month. That gives me a simple return from month to month on whatever number of lots that I trade.

For example, let's say I only trade 1 full lot per position, i.e. $10,000. I make 20 trades that month, so I've traded a total of $200,000, which averages to $10,000 per trade. That's because I didn't actually trade that much at once: I made 20 trades reusing the same $10,000. So, if my net gain for the month, i.e. my P/L, is $2,000, then I've made 20% that month against that $10,000.

Next month, I do the same number of trades, but I only make $1,000. My return on that $10,000 for that month would be 10%.

If I get into compounding the first month's $2,000 gain into my trading bank of $10,000, I'd then be trading a bank size of $12,000, and that would then become the divisor. See, it gets a little complicated in real time doing this; after the fact computer analysis is a snap.

Anyway, over the 2 months my gain is $3,000 divided by the same static $10,000 traded, or a 30% return. Averaged over the 2 months this becomes 15% return per month. That would give me an annualized return on risk of 180%.

Though 180% return may sound outrageous, if you can average making 10 pips a day, 4 days a week for 40 weeks, that's a $16,000 gain, or 160% simple return on your static $10,000.

Of course, you can't have any big losers along the way, and you have to consistently average 10 pips a day for 160 days....

This is why my goal is to make just 0.5% a day, 3 days a week, for 40 weeks. That 0.5% is $5/$1,000, or $50/$10,000. Just 5 pips trading a full lot over that period is $6,000, or 60% simple return on my $10,000 static bank.

Why would I do anything else that would complicate that?

I wouldn't, and I don't....

Video: FOREX Trading Rates of Return Calculations