Power of Compounding and Options Trading

Power of Compounding and Options Trading can give your investments explosive growth

The power of compounding is your best friend when it comes to growing wealth. In very simple terms, a sum of money even when invested at a moderate rate of interest, compounding regularly, can grow to a huge corpus in a relatively short period of time.

Albert Einstein, arguably one of the most intelligent men to have walked this planet, called compound interest, the “Eighth wonder of the world”. He described it as the most powerful force on the planet.

It is this power of compounding that I suggest you use to grow your corpus to allow you to move towards financial freedom in the long run.

The key here is moderate returns and regular compounding. Your corpus should be generating regular, positive returns and the returns should be reinvested.

How to generate regular and moderate positive returns?

The next obvious question is, where can you invest your money to generate such “regular and moderate positive returns”? Let us see some of the investment options commonly available to people:

  • Bank Deposits

Putting money in the bank is the safest investment that one can make. Hence the saying, “safe as money in the bank”. The bank pays you an interest on the money deposited in your account.

The biggest downside of this safety is the very low rate of interest. Historically, this rate does not even beat inflation. Hence your money actually loses its buying power with time if kept in the bank. Bank deposits certainly aren’t the way to create a compounding corpus.

  • Precious Metals

Precious metals like gold and silver have traditionally been the store of value. Their prices can especially go up in times of inflation. But they are also lacking as a way to generate steady and moderate positive returns. As we have seen in the past few years, their prices can go down and stay depressed for long periods of time. If you happen to need money during such a period of depressed prices, you will have to book your losses. Also, there is no straightforward way of making regular income from gold or silver while you hold them.

  • Commodities

These days it is possible to invest in particular commodities and it may give you healthy returns also. The downside with commodities is that you need to know very well, the commodity that you plan to invest in.

Also, with the recent slowdown in China (the biggest consumer of many commodities), that started in 2015, commodities are predicted to enter a multi-year bear market. It certainly isn’t my preferred method to generate long term, regular and moderate returns.

  • Art and Collectibles

Some people invest in art and collectibles and it can be very rewarding if you can pick winners. The one very big problem with art is that it has restricted liquidity. Outside of the well-known masters, most art has few buyers making price discovery very difficult.

Even if you have the “eye for art”, I find it closer to playing the lottery instead of making an investment. Also, there is no way to generate regular income with art. Unless you are an art dealer, I would recommend you stay clear of it for investment purposes.

  • Real Estate

Real estate is a popular form of investing among many. It indeed has formed the base for large fortunes. If invested and managed well, it can be a good investment over a long period of time. Real estate offers potential for both regular returns and capital appreciation.

While real estate solves many of the problems discussed above, it suffers from some of its own downsides as an investment vehicle. Real estate tends to be lumpy and illiquid. Home prices in many cities in North America tend to start from $300,000. Here, I am talking about live-able homes that you would want to invest in. even with 80% leverage and 20% of own money, we are looking at a minimum investment of $60,000.

There definitely is a possibility of generating a positive monthly cashflow through rental real estate, but such properties are not easy to find. Real estate comes with its management challenges and if you are not a hands-on person, repair and maintenance may eat significantly into your profits. Moreover, the 2007-08 sub-prime crisis has shown us that real estate prices need not necessarily always go up.

  • Stocks

Possibly the most famous method of investing, stock investments, over the long term, have created more millionaires than any other investment. Investing in stocks is easy to start and you can start with a small sum of money. Stocks of most good companies tend to be liquid.

But investing in stocks comes with two big downsides. One, stocks move in multi-year cycles. If you happen to get in near the top of a cycle, it may take you many years to break even. Two, apart from dividend, for the majority of people, there is no other way to make regular income from stocks. And dividends tend to be a tiny percentage for many fast growing companies – the like that you would want to invest in.

If we compare the above options available to normal people, real estate and stock come out on top. Indeed, it is no wonder that that is the investment method followed by most people.

My preferred way of investing is via stocks of good, large cap companies. But I use options trading to remove the two downsides that we discussed above. With those eliminated, stock investment with options trading gives a near perfect way to generate regular and moderate positive returns which when compounded give a big corpus.

I use my options trading excel to see the payoff profile for my different options positions instantly.

Let us see by an example, how you can grow your corpus enormously by targeting a, not very ambitious, 3.5% monthly return (quite possible using the options techniques described) over a period of 10 years. The table below shows the value of your corpus if you start with $20,000 and generate a return of 3.5% per month. Just see how the power of compounding can grow your wealth.

Investment Horizon

Value of corpus

After 2 years

$45,667

After 5 years

$157,562

After 7 years

$359,765

After 10 years

$1,241,286

What $20,000 can become in 10 years with the power of compounding at a 3.5% monthly return

Let’s look at the same table at 5% monthly return. While 5% monthly return is not something that I recommend you target from Day 1 but, as time passes, you will get better. You can start aiming for higher returns with time.

The table below is to open your eyes to the possibilities and power of compounding. See what happens to $20,000 if compounded for 5% every month.

Investment Horizon

Value of corpus

After 2 years

$64,502

After 5 years

$373,584

After 7 years

$1,204,845

After 10 years

$6,978,240

What $20,000 can become in 10 years with the power of compounding at a 5% monthly return

The options strategies that I use give 3-10% monthly returns. Of course there are months where I suffer a loss but I always buy protection so that the loss is limited. Also, there are also months where the returns are more than 10%. In favorable market conditions, your monthly returns using the strategies that I discuss can even go up to 20-30%. Hence, average compounded monthly returns of 3.5% to 5% are quite possible to attain.

For a quick recap, here are the investment options available and how they compare on the important criteria used to evaluate investment options:

Regular Returns

% Returns

Liquidity

Specialized Knowledge

Management

Bank Deposits

Yes

Very Low

Yes

Not Required

Low

Precious Metals

No

Variable

Yes

Required

Low

Commodities

No

Variable

Yes

Required

Low

Art and Collectibles

No

Very Variable

No

Required

Low

Real Estate

Yes

Moderate and Variable

No

Required

High

Stocks

No

Moderate and Variable

Yes

Required

Moderate

Stocks with Options

Yes

Moderate and Fixed

Yes

Required

Moderate

You can see above that from the different investment options available to the common person, investing in stocks and generating a steady income with options based on your investment represents the most certain way that you can use to generate regular and moderate positive returns.

About the Author Gaurav Dhir

In my various avatars, I am an Options Trader, an Author and a Coach. I use Options Trading to create a source of passive income for my family and myself. I am also using the cash flow from Options Trading to create a long term portfolio of stocks. You can easily learn and replicate my methods, just go ahead and explore my blog.

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