beginners corner

Compounding our Covered Call Writing Profits

When studying investment basics, I’m reminded of a quote from none other than Albert Einstein who called compounding “the greatest mathematical discovery of all time”.

Stated differently, a dollar received today is worth more than a dollar received tomorrow. This simple but powerful sentence sums up the concept of the time value of money (TVM). It is true because of the earning capacity of money when it is invested and then re-invested. In my books and videos I listed the reasons why I sell options. One of those motives states “You can compound your profits in a matter of minutes”. This means that when the cash is immediately generated into our accounts from the sale of the call options, we can turn around and invest these profits. The sooner we put this money to work, the wealthier we become.

Future Value and Compounding:

Future value projects what an investment will be worth at some point in the future. For example, if we invested $10,000 for 5 years with a simple annual interest rate of 5%, a $500 per year profit would be gained each year for a total profit of $2,500. The future value of the investment is $12,500. Had we re-invested the $500 profit each year, thereby compounding our money, the resulting future value would be $12,762.82. Now let’s expand our time frame to 30 years. With simple interest our future value comes to $25,000 ($10,000 + $500 per year for 30 years). By using the power of compounding and re-investing each $500 interest payment the future value balloons to $43,219.42. As compounding periods increase, so do our bottom lines.

Internal Rate of Return (IRR):

IRR is a way to analyze an investment considering the time value of money.  It basically calculates the interest rate which is the equivalent of the dollar amount your investment will return. Once you know the rate, you can compare it to IRR rates on other investment opportunities, or compare it to the actual cost of borrowing money for your investment.  For example, if you borrow money and pay annual interest of 6%, your investment should show an IRR a lot higher than 6%. If we were able to increase our IRR from 5% to 6% in the above example, our future value would grow from $43,219.42 to $57,434.91. A 2% increase to 7% would result in a future value of $76,122.55. Never underestimate the power of compounding. This is why I immediately re-invest my call premiums whenever possible and my strategy philosophy is to reinvest premium profits rather than to use them to reduce my cost basis.

Compounding and the Rule of 72 

This is a rule stating that in order to find the number of years required to double your money at a specific interest rate, you divide the annual compound return into 72. The result is the approximate number of years that it will take your investment to double. You can also calculate the interest rate required to double your money in a given amount of time. Here is a chart showing both calculations:

Growth Rate Time Required to Double Calculation
4% 72/4 = 18
6% 72/6 = 12
8% 72/8 = 9
9% 72/9 = 8
10% 72/10 = 7.2 (years)
18 72/18 = 4
12 72/12 = 6
9 72/9 =  8
8 72/8 =  9
7.2 72/7.2 = 10

                           Compounding your money

 If we could achieve a conservative 2% per month return in normal market conditions, our annual rate of return would be 24%. That means our time to double our investment would be 3 years (72/24). An investment of $100k could grow to $1.6M in a 12 year time frame. That demonstrates how powerful compounding can be for our financial futures. 

Covered Calls vs. Treasury Notes:

Let’s first state the obvious. We are comparing a low-risk investment to a no-risk investment. For undertaking that risk, we will be well paid in most market conditions. I want to focus on the compounding advantages of covered call writing compared to other investment vehicles. When we purchase a treasury note or bond @ par ($1000), we are guaranteed a specific interest rate or coupon. Let’s say that rate is 5% (wishful thinking!). Each year we will receive $50 in interest paid in two payments of $25 starting in 6 months and then a second installment six months later. When we sell a covered call option, that premium is instantly generated into our accounts and available to re-invest that same day or the next. If the cash is not needed, it behooves us to re-invest that income and start the geometric progression compounding offers us as a path to great wealth.

Conclusion:

Each investment strategy has its unique advantages and disadvantages. Covered Call Writing allows us to generate initial profits instantaneously. It makes no sense to let this cash simply sit in our accounts. If we pull the money out and head to the local mall, we have created an opportunity lost. The earlier that money goes to work for us, the sooner we will no longer need to go to work ourselves. That is the power of compounding…the eight wonder of the world. Can’t argue with Albert Einstein!

The BCI team is in Las Vegas:

BCI team members and I will be in Las Vegas from the 13th through the 16th as an invited speaker at the Forex and Options Trading Expo @ the Paris Hotel. Every effort will be made to publish our weekly stock report as early in the weekend as possible although it may be published a bit later than usual. We will catch up on all on and off site comments and inquiries next week. All books and DVDs ordered over the weekend will be shipped on Monday.

Market tone:

On Thursday Fed Chairman Ben Bernanke announced a third round of quantitative easing (QE3) to encourage borrowing by  buying $40 billion in mortgage-backed securities starting on Friday. He also announced that target short-term interest rates will remain near zero through mid-2015 while stating that monetary policy “cannot cure all economic ills” Other ecominc reports included:

  • First time unemployment claims came in higher than expected
  • CPI rose 0.6% in August
  • Core CPI (excluding food and energy), however, rose only 0.1%

For the week, the S&P 500 rose by 1.9% for a year-to-date return of 18.4%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish favoring out-of-the-money strikes.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

13 Responses to “Compounding our Covered Call Writing Profits”

  1. Alan Ellman September 15, 2012 10:02 am #

    Just a reminder that my team and I are in Las Vegas presenting a seminar at an options expo and will catch up on on and offsite contacts during the week.

    Alan

  2. Hamp September 15, 2012 9:20 pm #

    Alan,

    Do you ever take into consideration a recent spike in the price of a stock, high PE or PEG ratios, or stocks at 52 wk highs when considering ITM/ATM/OTM cc’s? I am a little hesitant at time to pull the trigger with some stocks that seem to have very pricey multiples or stocks that have shot up over the last few weeks/months.

    • Alan Ellman September 17, 2012 4:41 pm #

      Hamp,

      Many investors share your concerns. The screening process that is inherent in the BCI methodology will do much more than evaluate PE or PEG ratios (If I did consider one or the other, I’d go with PEG). So we are starting with securities that are fundamentally “elite” Now stocks that have approached 52-week highs can be viewed in 2 ways:

      1- They are due to decline (profit-taking)

      2- Nobody is losing money in the stock so investors looking to break even from a formerly losing position are non-existent.

      The BCI methodology addresses this issue as well. Our technical screens will evaluate two momentum idicators and look for volume divergence to identify a change in trend. If the trend is still our friend and momentum is bullish with strong volume confirmation, I’m still in the game.

      IF my market assessment is bullish and chart technicals are bullish and confirming, I have no problem going with OTM strikes even if the stock is approaching a 52-week high. It’s like doubling down in blackjack when you have an eleven and the dealer shows a “6”…time to make some money!

      Those with lower risk tolerance may opt for ITM strikes and still do very well.

      Alan

  3. Barry B September 16, 2012 11:40 pm #

    Premium Members,

    The Weekly Report for 09-14-12 has been uploaded to the Premium Member website and is available for download.

    This report is published a bit later than normal due to The BCI Team participation the Forex and Options Expo in Las Vegas this past weekend. Look for Alan’s interview from the show floor on the Money Show website. We’ll post the details as soon as we get the information from the expo managers.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The BCI Team

  4. Alan Ellman September 17, 2012 9:04 am #

    Running list stocks in the news: ASH:

    On July 26th, Ashland (maker of specialty chemicals like Valvoline automotive lubricants) reported another stellar earnings report where profit from continuing operations doubled year-to-year and revenues increased 23.5%. It was its 7th positive earnings surprise in a row and 11th in the past 12 quarters. As a result, earnings estimates are on the rise and on September 13th ASH hit a 52-week high @ $77.62. It is also a value stock with a forward PE of 11.8 (below 15 shows value) and a price-to-book of 1.4 (under 3 shows value). Our premium “running list” shows an industry segment rank of “B”, a beta of 1.55 and a dividend yield of 1.20.

    Alan

  5. Alan Ellman September 17, 2012 9:14 am #

    From our BCI team:

    Thanks to our members who we met at the Las Vegas Options Expo. It was great meeting you in person. We had a great time and received wonderful feedback on our presentation.

    Based on a few dozen emails we received when we returned there evidently was a glitch with the website which evidently decided to morph into a different structure. It reminded us of teenagers whose parents returned from a weekend trip asking them…”what keg party?” because aside from your emails, the site is currently where we left it before our trip. Our webmaster will look into this matter.

    There are a few hundred emails that have accumulated since Thursday and our team will reply by the end of this week or early next week.

    Thanks again for your unprecedented support.

    Alan and the BCI team

  6. Alan Ellman September 19, 2012 9:58 am #

    1, 2 and 3:

    My books were recently ranked as the top 3 best selling books on amazon.com on the subject of covered call writing. My latest book (Encyclopedia…) is the top-selling book on this topic. For this author, that news is rewarding, exciting but most of all humbling.

    Thank you.

    Alan

  7. Susan September 19, 2012 7:57 pm #

    Alan,

    What role does implied volatility play (if any) when making decisions on strike prices?

    Thanks,
    Susan

  8. Alan Ellman September 20, 2012 2:34 pm #

    Susan,

    I am extremely cautious about using (selling) an option where the IV is such that an ATM strike returns > 7% for a 1-month option. In normal market conditions my goal is 2-4% of time value for my initial option return. I am more likely to go higher in bull markets. This DOES relate back to the “moneyness of options in that I will go with OTM or ATM strikes and higher IVs in bull markets and lower IV options and ITM strikes in bearish and volatile markets.

    Alan

  9. Dave September 21, 2012 12:53 am #

    Hi Alan

    Is there any risk with purchasing pharmseutical companies?

    Also, ROSS is said to be releasing its earnings on the 17/11/12… (according to IBD) Its also a stock on a previous list of stocks to avoid due to same month sales ect… Would you avoid this stock Alan?

    Cheerio Alan

    Thanks

    Dave

    • Alan Ellman September 21, 2012 7:26 am #

      Dave,

      If a pharmaceutical has an impending FDA approval, it represents risk we are not willing to take. The market will recognize this and cause the implied volatility of the option to rise. If I see a 1-month return > 7% I will avoid an option for this very reason (too risky).

      I would absolutely avoid Ross Apparel (ROST) as an underlying security for covered call writing. Since it reports same store retail stats on a MONTHLY basis it is on our list of “banned” stocks.

      Alan

  10. Ray October 4, 2012 3:40 pm #

    Alan,
    What exactly do you mean by “my strategy philosophy is to reinvest premium profits rather than to use them to reduce my cost basis.”

    I would figure that as soon as you recieved payment for selling the covered calls, that money could be invested into either more of the same stock, or some other stock. Thus, if you received a heftly payment (enough to purchase 100 share atleast) you could then sell more covered calls in the same day.

    • Alan Ellman October 4, 2012 5:21 pm #

      Ray,

      Your assessment is 100% spot on. The initial profit (time value only) is re-invested ASAP as long as the investor does not need the cash for other needs (I used to take these profits to help subsidize my sons education, but now their off the payroll!).

      Most covered call writers use these profits (from an accounting perspective) to decrease the cost basis, a different philosophical approach (buy @ 30, sell call for $1, cost basis $29). Compounding initial profits is a key cornerstone to the BCI methodology.

      Alan

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