Amplify Gains Through Compounding

Compounding, when you reinvest the principal plus any interest and gain, is a powerful force in investing.

Let’s say you invest $1,000 in a 5-year CD that pays you 3% interest, compounded once at the end of each year. At the end of 5 years, your total return won’t be 15% (3% x 5 years). It will be higher.

As the table shows, at the end of Year 5, when the CD matures, you would get back $1,159.27, for a 15.9% return.

At the end of Year 1, the bank pays you $30 in interest so your CD is worth $1,030. This means in Year 2, you would actually be earning interest against $1,030, not the original $1,000. And each year, you earn 3% on a higher starting amount because of interest received from the year before. The 3% interest on the annual interest you earn over the 5 years is what accounts for the extra return.

I chose a high interest rate to accentuate the effect of compounding. Realistically, in today’s ultra-low interest environment, you wouldn’t be able to get 3% for a CD, but the point stands.

With the interest rate so low, you are barely going to earn a return for investing in fixed income. This is why investor appetite has returned for riskier assets—like stocks and options.

Compounding With Options

When it comes to options, compounding can really amplify returns.

For example, you start with $500, buy an option and sell it for a 20% gain ($100). You end up with $600. To maximize your earning power you invest the whole $600 into another option trade. Let’s say you make another 20% ($120), which means you would have $720 to invest in the next trade.

The table below summarizes how much you would have after each trade. If you have a 20% return with each trade, after five trades that $500 has grown into $1,244. That’s a 149% return!

If you only invested the original $500 each time and made 20% ($100) with each trade, after five trades you would have made $500, a 100% return. This means by reinvesting your gains, through compounding you improved your return by $244, or about 49%.

Understand the Risk

The potential downside to putting everything into every trade is that if even one of the trades turns out to be a loser, it could eat significantly into your gains. In the above example, if you lost 20% on Trade 3, but gained 20% in every other trade, your overall return would go from 149% to 66% ($329). Thus, it’s important to understand that the more money you invest, the bigger the potential gain, but also the bigger the potential loss.

Still, continuing with the above example, if you didn’t compound and invested only $500 into each trade, and lost 20% in one trade and gained 20% in the other four, your overall return would be 60% ($300). In other words, your overall gains would be higher in the compounding scenario.

The examples I gave are purposely simplified to show how compounding can help lead to even faster gains in option trading. I also ignored the commission cost of option trading, which depending on your broker should be under $1 per contract. In practice, how much you reinvest into the next trade would depend on your risk tolerance and your confidence in each trade. You could also deploy various option-trading strategies to manage risk.

The bottom line is that you should understand your financial situation and know what your investing goals are. Determine how much you can afford to risk and how much money you are looking to make. No one knows your situation better than yourself.

Editor’s Note: Our colleague Scott Chan just provided you with timeless investing advice. Scott is the lead analyst on our premium trading service, The Complete Investor. The chief investment strategist of TCI is Dr. Stephen Leeb, a renowned financial expert.

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