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Simple Interest And Compound Interest

In Volume 1 of the Complete Encyclopedia for Covered Call Writing, I addressed the importance of compounding profits and discussed the Rule of 72 (the time it takes to double your money based on annualized return on investments). In this related article, I will highlight the difference between simple interest and compounded interest and therefore the impact re-investing our profits will have on our financial security.

When I started using covered call writing as the primary strategy in the stock portion of my portfolio, I needed the profits to support family matters like college, professional school and real estate investments. The cash generated from options sales was used to meet the needs my family had at that time. Several years later there reached a point when I no longer had those family needs (the kids were off the payroll!) and re-investing those profits took precedence. That’s when I was introduced to the 8th wonder of the world…the power of compounding.

 

Definitions

Simple interest: The interest paid on the original principle only.

Compound interest: Interest earned not only on the original principle, but also on all interest previously earned.

 

Formula and example for simple interest

Interest = principle x rate of return x time

If we invested $5,000.00 @ 10% per year for 4 years out interest would total:

$5,000.00 x 0.10 x 4 = $2,000.00

4-year return = $7,000.00

If the cash generated from the sale of options is needed for family matters this would be your returns.

 

Formula and example for compound interest

The formula is somewhat complicated and beyond the scope of this article so let’s calculate the above example over the 4-year time frame and compounding or re-investing our earned interest.

Year 1: $5,000.00 x 0.10 = $500.00 = $5500.00

Year 2: $5500.00 x 0.10 = $550.00 = $6050.00

Year 3: $6050.00 x 0.10 = $605.00 = $6655.00

Year 4: $6655.00 x 0.10 = $665.50 = $7320.50

 

Total interest earned via annualized compounding:

$500.00 + $550.00 + $605.00 + $665.50 = $2320.50

After 4 years, compounding generated $320.50 more than simple interest for the same initial investment. The results would be even more dramatic if compounding took place quarterly or monthly and if additional funds were added to the initial investment. Needless to say, the longer the time frame the greater the impact compounding will have on our financial futures.

Compound calculators

These calculators can be found free on the web with such sites as:

www.bankrate.com

Here’s what the above example would like when plugged into one of these tools:

 

compounding covered call writing profits

Compound calculator put to work

 

Lesson-learned from the opposite perspective

Let’s say we are borrowing money as opposed to generating income. Here compounding can become a nightmare and keep us in debt forever. If we borrowed $5,000.00 @ 10% that would result in a yearly interest debit of $500.00. If we paid only minimum payments of let’s say $100.00, the next year we would pay 10% of $5400.00 or $540.00. This why credit card companies encourage us to make only minimum payments. So which side of compounding should Blue Collar Investors reside? A rhetorical question, wouldn’t you say!

 

Next live seminar:

Saturday, June 14th

8:30 – 11 AM

Costa Mesa, California (Orange County)

BCI members who will be attending may want to get to the venue a bit early. I’m told by the chapter President that they are expecting a much larger attendance than normal based on the number of recent inquiries from non-chapter members.

Click for more information and registration

 

New seminar just added:

Saturday April 11, 2015

Charlotte, North Carolina

For a complete 2-page list of all upcoming events click on this link.

 

A lot of interest in Apple Computer (AAPL):

This is not a scientific study but I can tell you that since AAPL earned its way onto our Premium Watch List, there has been huge interest in this company from our members based on emails I have been receiving. The main reason is that as of June 9th, AAPL will split 7-for-1, meaning its shares will be trading @ about $90 per share instead of the current $635 per share (mid-day Friday). This sure makes it a lot easier for retail investors to purchase in 100 share increments. In addition to this, AAPL is soon to launch 2 new products: a new iPhone and an iWatch. Historically, AAPL out-performs prior to the launch of a new product. With the price of AAPL so high, I decided to check the PEG ratio of this company and compare it to that of other tech stalwarts:

  • AAPL: 0.95
  • MSFT: 2.19
  • ORCL: 1.37
  • IBM: 1.18

AAPL is still “cheap”

 

Market tone:

Despite bearish GDP estimates, the market reacted favorably in this shortened week and consumers remained confident:

  • The Commerce Department reduced its 1st quarter annualized GDP estimate to – 1% worse than the -0.5% expected. Once again, severe weather seemed to play a major role in the decline
  • According to the Commerce Department, durable goods orders (a measure of the number of orders for a broad range of products—from computers and furniture to autos and defense aircraft—with an expected life of at least three years. Durable-goods orders are a leading indicator of industrial production and capital spending. Data fluctuate widely from month to month and are often subject to significant revision) increased by 0.8% in April, the 3rd consecutive monthly increase. The March increase was also revised upward from 2.6% to 3.6%
  • Personal income increased by 0.3% in April, as expected
  • Personal spending moved down by 0.1% in April, the 1st decline in a year but after March’s 1% increase, the largest in 4 years
  • The rate of savings increased to 4% in April from 3.6% in March
  • Initial jobless claims for the week ending may 24th came in @ 300,000, less than the 318,000 expected
  • The Conference Board’s consumer confidence index (a gauge of consumers’ attitudes about the present economic situation as well as their expectations regarding future conditions. Consumer confidence tends to have a strong correlation with consumer spending patterns) rose to 83.0 in May, the 2nd highest reading in more than 6 years

For the week, the S&P 500 rose by 1.2%, for a year-to-date return of 5%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish favoring out-of-the-money strikes 3-to-2

Thanks for all your support and putting The Blue collar Investor on the financial map,

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.

6 Responses to “Simple Interest And Compound Interest”

  1. Barry B May 31, 2014 11:33 pm #

    Premium Members,

    The Weekly Report for 05-30-14 has been uploaded to the Premium Member website and is available for download.

    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

  2. Saul June 1, 2014 12:08 pm #

    Alan,

    I recently sold the Apple 620 call option for June. Since there will be a price change on the 9th how will this effect my position?

    Thanks for all your help.

    Saul

    • Alan Ellman June 1, 2014 12:40 pm #

      Saul,

      There is no one formula that applies to all contract adjustments. In the case of AAPL, it is straightforward. The number of contracts sold goes from 1 to 7 and the strike price of 620 is divided by 7: 620/7 = 88.57. Below is a screenshot showing the contract adjustments as seen on the CBOE site. CLICK IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO THIS BLOG.

      Alan

  3. Adrian June 3, 2014 3:49 am #

    Alan, I need to ask a rather long question below, of the charts versus the better returns so to choose the best stocks.

    – Sometimes when I select stocks off the running list using my own order of priorities for this, I find that the % return on my selected strike prices to not be very high. The technical charts(my top priority) may look perfect and trending up(or at least above the EMA’s), but I would then find poor calculated returns from around the 0.5% – 1.5% ranges.
    Do you suggest I keep going through the running list in my maximum price range until I get at least five stocks with a minimum 2% return, – or should I just use these stocks anyway with great chart technicals, rather than some that may have a “2%+” returns but maybe also a more concerning chart situation to them? (eg. resistance level just above price, etc)?
    What do you think is best to do in this situation? Thanks

    • Alan Ellman June 3, 2014 7:02 am #

      Adrian,

      One of the many benefits of the BCI methodology is that you can adjust the techniques to your personal risk tolerance. I have published a myriad of times that my goal for initial option returns is 2-4%/month but in my mother’s account I use a more conservative 1-2%/month. We have many members that set higher goals with greater risk.

      For a full month (we are currently mid-contract) I rarely have an issue finding an adequate number of underlying securities that meet my goal. If you are looking only @ stocks in bold (strongest technically) I can see where this would be a problem.

      One reasonable approach to this dilemma would be to look at all eligible stocks (even non-bold…these are still great candidates) and write in-the-money strikes if technicals are of concern. I have found over the years that even stocks with mixed technicals will out-perform in bull market conditions and using out-of-the-money strikes can enhance returns. In neutral or slightly bearish markets, stocks with mixed technicals can be matched with the more conservative ITM strikes.

      Alan

  4. Adrian June 4, 2014 3:07 am #

    Alan, thanks again for that detailed answer given. So I would most likely go through more stocks in the lookout for higher returns, and possibly sell ITM options too.
    But it’s here I have to also assume that if I wanted to sell an OTM strike on a stock with great chart technicals yet the return is too low for this strike, but happens to be in my 2-4% goal for the ITM strike, then going with this ITM strike(regardless of the chart) is what I guess I would do here – please tell me if this is wrong.

    – And it’s now that I have 2 questions about after-hours practice, and the last one on an alternative chart for comparing price performance.
    1. Firstly if I have been papertrading the shares after-hours because of the time difference where I am from, and wondered whether this should only be done during market hours, or could I keep putting on practice trades after- hours?
    2. Would you say that the premiums usually are a bit higher during market hours compared to after-hours when market closed?
    3. And something I forgot to ask you the other week back is, when I go to compare the price performance (S&P500) to any stock, then could I instead of using the “price comparison” on my chart software use the “relative strength” line? (if not then it doesn’t matter, it just seems easier to plot trendlines on the RS line than the other one, which is shown behind the price.)?

    I’ll get back to do a bit more chart study so may not post here again for a while but thanks for your time in helping me.

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