3. What is the power of compound interest?

Compound interest allows you to earn interest not only on the initial amount, but also on the interest accrued earlier. Thus, at the end of each new period, interest is accrued on the entire capital – the initial investment plus the accumulated interest income.

Suppose you open a bank deposit of 20,000$ with an interest rate of 10% for a period of 3 years. The interest is compounded and accrues once a year:

– for the first year you will receive income in the amount of 2000$. – 10% of the deposit;
– for the second year 10% will be accrued on the amount taking into account the income already received, i.e. 0.1 * (20 000$ + 2000$ ) = 2200$ or 11% of the deposit;
– income for the third year will amount to 0.1 * (22 000 $ + 2200 $) = 2420 $ or 12.1% of the deposit.

The total profit in our example will be equal to 6620$ or 33.1% of the initial investment. In case of simple interest, the income would be 30% or 6000$. The advantage of compound interest is in obtaining progressive income: the amount of interest, equal to the ratio of income for the period to the initial amount of investment, is accelerating every year.

Similar to a bank deposit, interest capitalization is reflected in trading. A speculative trader seeks short-term profit, so he looks for instruments with high short-term volatility, the price of which changes a lot during one or several trading sessions.

An investor trader, on the other hand, looks at long-term investments ranging from months and years to decades. Compound interest can affect the bottom line of both groups of traders, although it plays a more important role for investors.

Compound interest in investments

et us consider how compound interest works in the case of dividends. Suppose you bought 100,000$ worth of shares with a constant dividend yield of 5% per year and constantly reinvest them in shares (i.e., you buy shares for the amount of dividends received). After 10 years, the earnings from dividends alone will be equal to 63,000$ . By the end of the 20th year, the income will reach 165,000$. If you hold the shares for 30 years, the dividend income will grow to 332,000$, which is 332% of the initial investment. If the trader withdrew the profit every year, the compound interest would turn into simple interest, and the earnings for 30 years would amount to 150% – 2.2 times lower than in the first case.

This difference arises due to the fact that reinvested dividends bring additional dividend income in the future. In this case, the so-called “snowball effect” is triggered: each year dividends paid from reinvested dividends increase with acceleration. It should be understood that the more often a company makes dividend payments, the stronger this effect becomes.

The same effect is true for bonds. By investing in coupon bonds, which pay a certain interest (coupon) at predetermined intervals, a trader can also increase his earnings by reinvesting the coupon income. The principle of compound interest is the same as in the case of dividends. Bonds with a monthly coupon payment will have a greater progressive income effect. Note that in the QUIK trading terminal the bonds’ yield to maturity is already calculated as an effective rate, i.e. taking into account reinvestment of coupon payments.

Compound interest in speculative trading

The use of compound interest is also possible when dealing with futures. For example, the current market price of a futures is equal to 160,000$ , and the security for the futures is 20,000$. Having 45,000$ , the trader decides to buy 2 futures with a guarantee of 40,000$ . Two weeks later, the price increases by 5%, providing income accrued in the form of variation margin:

2 * 160,000$ * 0.05 = 16,000$ .

The speculator has an opportunity to buy 1 futures for 20,000$ at the expense of free cash (5000$) and variation margin (16,000$ ). Suppose that in three weeks the futures price has increased by another 5%:

3 * 168,000$ . * 0.05 = 25,200$ .

One third of the income ($ 8,400) was provided by the futures purchased earlier. Thus, the variation margin used to purchase futures is capitalized as in the case of dividends or coupon payments. The key difference is that in order to obtain the effect of compound interest on futures, the dynamics of its underlying asset must be almost continuously rising (falling when selling futures).

Since this approach involves holding an all-cash position, there is a constant risk of losing a significant portion of the funds. This may happen in case of a sharp unfavorable price change, especially if there is not enough collateral to hold the entire position. In the latter case, the losing position will be forcibly closed.

When implementing the above strategy, the trader himself chooses the period for reinvestment, but not before the moment when the variation margin with free funds will allow to buy/sell at least 1 futures. High risks of the strategy imply that the trader will be able to determine the moment of price reversal and fix the profit in time.