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.
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.
These calculators can be found free on the web with such sites as:
Here’s what the above example would like when plugged into one of these tools:
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.
New seminar just added:
Saturday April 11, 2015
Charlotte, North Carolina
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”
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.
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 ([email protected])