Options Trading:

The Power to Make Money in Any Market Situation

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Options Trading:
The Power to Make Money in Any Market Situation

Notice This publication and the accompanying materials are designed to provide accurate and authoritative information in regard to the subject matter covered in it. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional opinions. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Reproduction or translation of any part of the information contained herein, in any form or by any means, without the written permission of the owner is unlawful. All stock and options trading involves risk and may not be suitable for all investors. One must be aware of the risks and be willing to accept them in order to invest in the stock and/or options markets. The companys seminars, products, and/or newsletters are for educational purposes only and no warranties are given or implied. Information contained herein is not a solicitation or a recommendation to buy or sell stocks and/or options. Any mention of specific securities are examples for illustration and educational purposes only. As always, consult your broker and do your own research prior to any trading decision. This information is for educational purposes only and no warranties are given or implied. Any decision to place trades is ones own responsibility. The company and/or their subsidiaries, business alliances, subcontractors, and/or employees are not liable in any form. At any point in time, the publishers and employees, subcontractors and alliances may own, buy, or sell the assets or options discussed for the purpose of trading. You must receive a copy of the publication Characteristics and Risks of Standardized Options (ODD) prior to buying or selling an option. Copies of the ODD are available from your broker, at http://cboe.com/Resources/Intro.aspx, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. 2011 Rich Dad Education. All rights reserved. The Rich Dad word mark and logos are owned by Rich Dad Operating Co., LLC and any such use is under license. 11RDES0112 v1 3-11

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OPTiOnS TrAding: The POWer TO MAke MOneY in AnY MArkeT SiTUATiOn

Many people have discovered the power of options. Their acceptance in everyday financial management is growing widely and they provide a nice compliment for the modern investment portfolio. Options can become a very powerful tool in the hands of the educated investor. They give investors the opportunity to make money in any type of market environment, regardless of whether or not the investors trading style is conservative or aggressive. And the versatility of options allows them to be used in a wide-range of investment strategies and goals. For example: You can increase income against current stock holdings. You can prepare to buy a stock at a lower price. You can benefit from a stock price rise without incurring the cost of buying the stock outright. You can create cashflow using stock that you own.

You have probably heard of the inherent risks in options and have been told they are primarily used for speculation. But in reality, options can be conservative or very aggressive, depending on the forecast you have for the stock and the strategy you want to employ. In fact, some of the earliest option applications were used to reduce risk rather than increase it. However, it is important to note that options are NOT for the inexperienced trader. Before you participate in options trading, you must develop a solid understanding of the risks and exposure when dealing with options, and you should be trained in the options market and how to use options to your advantage as part of an overall investment strategy. We offer such advanced training and will be glad to help you learn more about this unique opportunity.

Participating in Options
We should also stress at this point that we use options, but not by themselves. Most of our option trades are combinations of stock purchases and options or option/option strategies to generate what is called spread-trading. This is

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what many floor traders and fund managers use every single day. Strategies like straddle, bull call, and call ratio back-spread will become familiar terms and second nature to you if you continue your financial training with Rich Dad Education.

What Is an Option?
An option is a contract that derives its value from an underlying asset. That contract either gives the owner the right to buy the asset (Call option) or the right to sell the asset (Put option) at a predetermined price and within some predetermined timeframe. The key idea here is that the owner of an option has a right, not an obligation. If the owner of the option does not exercise this right before the predetermined time, then the option and the opportunity to exercise it cease to exist, and the option expires.

Seller (Writer)
On the other hand, the seller (writer) of an option is obligated to fulfill the obligations (requirements) of the contract if the option is exercised. In the case of a Call option on stock, the seller has given someone the right to buy the underlying asset. The seller of the Call option will be obligated to sell the stock to the Call option owner if the option is exercised. The owner of the options literally has the right to call the stock from you. With a Put option on a stock, the seller of the Put option has given the right to sell that stock to another party. The seller of the Put option is therefore obligated to buy the stock from the Put option owner if the option is exercised. The owner of the options literally has the right to put the stock to you.

Some Examples of Options

You may not realize this, but you are already familiar with options. Have you purchased insurance as a safeguard against a fire in your home, an accident with your car, or large medical bills? Do you pay a premium for your house, auto, and medical insurance? Then you have purchased a type of option. The fact is, options are a part of our everyday life, and have valuable application in our trading and investing pursuits. Auto insurance, health insurance, and homeowners insurance are all examples of Put options. These options transfer the risk of loss from the owner of an

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asset to the writer (seller) of the Put. Insurance companies are basically Put option dealers.

Leverage
Options take advantage of leverage. Leverage is the term used to describe the profit or loss potential when a small amount of money controls a large amount of money. In the example of an option, the owner of one Call option has the upside potential of 100 shares by investing a smaller amount of money rather than purchasing the stock outright. If there is a 10% rise in the stock, the option can double in value. A word of caution: leverage also increases our risk. A 10% decline in the stock can result in the total loss of what we paid for an option. Lets look at an example of the possible difference in returns when purchasing the stock outright vs. purchasing the option. Purchase 100 shares of stock @ $32 for a cost of $3,200. If the stock rises from $32 to $42, you would have a $1,000 gain, or a 31% increase. On the other hand, option or contract 100 shares of stock by purchasing the call at a premium of $3 per share for a cost of $300 (1 contract x 100 shares x $3 premium = $300). If the option premium rose from $3 to $11, the original cost was $300 and it is now worth $1,100. You have an $800 profit, but a 266% return! When comparing the stock purchase to the option purchase, your stock purchase will have a moderately high dollar profit. But your option purchase can have a significantly higher percentage return.

Why Are Options Considered Risky?

With the returns that options can provide, they can be very appealing. But those potential returns come from leverage, and that leverage also brings greater risk. For example, a ten percent increase in the underlying asset can potentially double your money in the options market. On the other hand, have a ten percent loss in the underlying asset, and you could lose the entire value of the option you purchased. Too many amateur investors or beginning traders do not take enough time to think about the potential downside before jumping in with leverage. So why would an investor consider options? In the end, it is all about control and

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choice. By having knowledge of options, we are no longer limited to the buy and hope strategy. We can now make money in any type of market situation. We can be very aggressive or we can be conservative, depending on our investing personality and objectives.

The Basics of Options

Before you actually start investing with and trading options, you need to understand the basic terminology (the language) of options and more about how they work. For example, you need to know the factors that affect the prices or premiums, and how that relates to the price of the underlying stock. We have already learned that an option is the right, but not the obligation, to buy or sell a stock at a specific price on or before a specific date. And we have learned that there are two types of options: Calls and Puts. To review: Calls The right to buy. The obligation to sell. Puts The right to sell. The obligation to buy. Now, lets learn a little more about how they work.

Contracts
A Call contract gives the buyer or holder the right to purchase the underlying asset and gives the writer or seller the obligation to sell a set number of shares of the underlying stock at a specified price (strike price) on or before the date the contract expires (expiration date). A Put contract gives the buyer or holder of the contract the right to sell the underlying asset and gives the writer or seller of the contract the obligation to buy a set number of shares of the underlying asset at a specified price (strike price) on or before the date the contract expires (expiration date). A contract usually accounts for 100 shares of stock. However, if there has been a recent split in the stock, this may not be the case. The buyer of the contract will pay a premium. The writer or seller of a contract will collect a premium.
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So as we can see, there are three components to an option contract. They are: Strike Price The level at which the contract gives you the right to buy or sell. Expiration Date The third Friday of the month (technically, its the third Saturday at 11:59 a.m.). Premium The cost of the option.

Now, lets take a look at an example of how these all relate together.

A Real-World Example
You are interested in building a golf course and have found a great piece of land in a potentially high-growth area. You evaluate your situation as follows: 1,000-acre property in an area of potential rapid growth. It will take time to get land permits, secure financing and deal with environmentalists. You want to secure the land while you put everything in place. You also dont want to purchase the land outright since it would be quite expensive and you may not get approval to build the golf course. Strike Price You go to the property owner and strike a deal that allows you to purchase the property for 2 million dollars. He agrees and you now have the right to purchase the property at the agreed upon price. Your solution is to go to the landowner and create a contract that will give you the right to buy the land, but not the obligation. The contract will account for all 1,000 acres. The price that you agree to is called the strike price. If you are not successful in obtaining the right to build a golf course, you can just walk away from the deal and lose only the amount it cost to purchase the contract.

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Expiration Date To offer some protection, the property owner inserts a clause that the contract will not be valid after six months. This creates an expiration date. The contract has an expiration clause written into it to protect the landowner from being obligated to sell his property for an unreasonable amount of time. It will also decrease the cost of the contract to you because we will only be tying up the land for a short, predetermined amount of time. Premium The landowner will collect a premium for being obligated to sell us the land for the agreed upon price. His price is based on how much the property might move in value during that period and how long he will have the obligation. The premium in our example is $20,000.

The landowner will expect to collect a premium for being obligated to sell you the property. The amount of money he expects will be determined by how long he will be under obligation and what the expectations are for the property to move up or down in value. The more time, the more money. The more likely the land will increase in value, the more money he will expect. You understand why you would be interested in doing this, but why would the property owner? First, he gets to keep the premium paid for the contract no matter what. Second, the agreed upon sale price (strike price) is likely to be much higher than he could obtain if he sold the property without obtaining the land-use approvals. The example above is much like a Call option in the stock market. Stock options are contracts that have strike prices, expirations, and premiums paid. Rights are transferred and the parties to the contract take obligations. Now, lets learn a little bit more about the components of our contract.

Strike Price
As you have learned, the strike price is the price per share at which you will have the right to buy or sell the underlying stock. For example, if you see May 30

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Calls, this means you have the right to buy stock at $30 per share. If you have written or sold a contract, it will be the price at which you will be obligated to buy or sell. Strike prices are determined by the exchanges and are in even increments as follows: Stocks costing from $5 to $25: Increments of $2.50 starting at $5 Stocks costing from $25 to $200: Increments of $5 starting at $25 Stocks costing from $200 to $60,000: Increments of $10 starting at $200

Expiration Date
This is the month when the option contract will expire. For standard options, the dates can range from one to nine months and expire on the Saturday following the third Friday of the month. However, since you cant trade on Saturday, the third Friday of the month is considered the option expiration date. If you see a quote for May 30 Calls, May refers to the expiration month and the actual expiration date will be the third Saturday of May. So, the option will no longer trade at the close of the markets on the third Friday of May, and will expire the next day. If the markets happen to be closed on that Friday, the last day to trade will be on Thursday.

Premium
This is the amount the buyer pays to purchase the option; it is the same thing as the options price. It is the amount that the seller of the option will collect for taking on the obligation of the contract. When looking at an option, you will see a bid and ask price, just like you would with a stock. Note that options in the U.S. are generally for 100 shares of stock. The premium or price is given for one share. If you see a May 30 Call at $4, the price for one contract is 100 shares multiplied by $4, or $400. (1 x 100 x $4 = $400). The premium is primarily affected by three things: Time The underlying asset price relative to the strike price The volatility of the underlying asset

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Options are a decaying asset - Time Value

In the last 2 weeks the weeks just before expiration - their decline in value accelerates This works in our favor when we are contract sellers
Week 4 Week 3 Week 2 Week 1

The value of an option is highly dependent on the amount of time left before the option expires. Options are considered wasting assets because they have a limited lifetime and their value decreases as their expiration date approaches. Time value is the portion of the premium that is dedicated to time remaining until a contract expires. When buying time, the purchaser of an option is buying the possibility that the option value will increase before the expiration date. As the option approaches expiration, its time value decreases toward zero. At expiration, the options value will be zero unless the option finishes In-The-Money.

In-The-Money, Out-Of-The-Money, and At-The-Money

In-The-Money (ITM), Out-Of-The-Money (OTM), and At-The-Money (ATM) are terms used to describe the relationship between an options strike price and the current price of the underlying stock. A Call option is considered to be ITM when the stock is trading higher than the options strike price, OTM when it is trading for less than the options strike price, and ATM when it is trading at exactly, or extremely close to, the options strike price. For example, if a companys ticker symbol was XYZ, the XYZ Oct 35 Call would be ITM if XYZ was trading for more than $35, OTM if XYZ was trading for less than $35, and ATM if XYZ was trading for exactly $35.

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Intrinsic Value
If an option is ITM, it has what is called intrinsic value (value if it were to be exercised). Intrinsic value is the difference between the stock price and the ITM strike price. In other words, it is the ITM portion of an options price. For example, a stock is trading at $37.50 and the strike price on the option is $35, therefore, the intrinsic value in the option is $2.50. The general rule of option pricing is as follows: ITM options are more expensive, however, ITM options go up in value faster as the price of the stock goes up. OTM options are less expensive, however OTM options go up in value slower as the price of the stock goes up.

Volatility
One of the most important aspects in determining the value of an option is the behavior of the underlying stock. There can be many different opinions from investors about how a stock might behave going forward. Individual option traders may also disagree about the value of any given option. That difference of opinion can affect the price of the underlying security dramatically. This brings us to a concept called volatility. Volatility is the measure of stock price movement. It is how much a stock price moves up and down. The greater the up and down movement, the greater the odds of an option being ITM during its lifespan. This greater chance increases the price of the option. Volatility of the underlying stock is a key factor in determining an options value. As the volatility of a stock increases, an options premium will usually increase. The difficulty of predicting the behavior of a volatile stock allows the option seller to command a higher price for the additional risk. This is one advantage to Call and Put writers.

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Reading a Quote Screen

Another key to moving forward with an options trade is to understand the quote screen you will be looking at when making an option purchase. Depending on your broker or the online service you use, the quote screen you work with may look different, but the information on almost all quote screens is the same. Information of the underlying security and its performance on the day is usually at the top of the screen. The options are then listed underneath. Calls will typically be listed on the left and Puts will be listed on the right. On a few screens, Calls will be at the top and Puts will be on the bottom. You will also see the available contracts as they relate to their expiration date. Just as every stock has a ticker symbol, so does every option. The first three letters or spaces correspond with the underlying asset (note: the letters do not need to be the same). The fourth letter corresponds to the expiration month. And the last letter corresponds to the strike price. The Month Code comes from this table:
Expiration Month Codes Jan Calls Puts A M Feb B N Mar C O Apr D P May E Q Jun F R Jul G S Aug H T Sep I U Oct J V Nov K W Dec L X

And, the Strike Price comes from this table:

Strike Price Codes A 5 105 205 305 405 505 605 705 B 10 110 210 310 410 510 610 710 C 15 115 215 315 415 515 615 715 D 20 120 220 320 420 520 620 720 E 25 125 225 325 425 525 625 725 F 30 130 230 330 430 530 630 730 G 35 135 235 335 435 535 635 735 H 40 140 240 340 440 540 640 740 I 45 145 245 345 445 545 645 745 J 50 150 250 350 450 550 650 750 K 55 155 255 355 455 555 655 755 L 60 160 260 360 460 560 660 760 M 65 165 265 365 465 565 665 765

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N 70 170 270 370 470 570 670 770

O 75 175 275 375 475 575 675 775

P 80 180 280 380 480 580 680 780

Q 85 185 285 385 485 585 685 785

R 90 190 290 390 490 590 690 790

S 95 195 295 395 495 595 695 795

T 100 200 300 400 500 600 700 800

U 7 37 67 97 127 157 187 217

V 12 42 72 102 132 162 192 222

W 17 47 77 107 137 167 197 227

X 22 52 82 112 142 172 202 232

Y 27 57 87 117 147 177 207 237

Z 32 62 92 122 152 182 212 242

You do not need to memorize these, just know that this information is all very organized and this is typically what you will see when looking at an options quote screen. For further help in reading a quote screen, additional information about the various fields is provided below. The Symbol will be the first column. Be very careful to make sure you are entering the correct symbol for the contract you wish to buy or sell. When working with some quote screens, you will see a period in front of the symbol. This is has to do with computer issues in generating the quote screen and does not need to be entered when placing orders. Sometimes, there is no period, but an .X following the symbol. Again, this is a computer programming related issue and is of no concern when entering orders. The Last time an option traded (was open or closed), this was the price at which the transaction took place. Be aware that it could have been a few days ago and might not reflect current market prices. The Bid is the highest price that any buyer is willing to pay for the option. When you are selling a contract, this is the price you will get for your options. The Ask is the price that a seller is willing to accept. This is the price you will pay when you are purchasing an option. The Vol (volume) is the number of contracts that have been traded for that day. The Open interest is the number of contracts outstanding or open. It is considered to be a measure of how liquid a market may be. Liquid means how easy it is to buy or sell. The Strike is the specific price of the option.

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Now that you understand some of the basic language and concepts of options, and have become familiar with reading an option quote screen, lets go over four key steps to making a profitable options trade.

Four Key Steps To Making a Profitable Options Trade

1. Options traders usually say that an option is only as good as its stock. Therefore, the first step in making a profitable options trade is to pick the right stock. 2. The next step is to decide whether you will buy a Call option or a Put option. Remember, if you think the price of the stock will go up, you will buy a Call option. On the other hand, if you think the price of the stock will go down, you will buy a Put option. 3. The third step is to estimate the strike price of the option. Determining the strike price involves looking at the following: Intrinsic value Remember, this is the value determined by the relationship of the stock price to the strike price. On a Call option, the intrinsic value is when the stock price is above the strike price. On a Put option, the intrinsic value is when the stock price is below the strike price. Volatility This is indicated by big and frequent fluctuations in stock prices. Speculative value Speculative value takes into consideration time value, volatility of the market, and interest rates to measure the probability that an option will be worth more prior to the expiration date. 4. And the fourth step is to choose an expiration date that will bring the most profit potential. Remember that the higher the premium, the more time you need to earn a profit.

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The "Options" Are Yours

As we noted at the beginning of this report, options trading is a skill that is not recommended for beginning traders. Rich Dad Education offers additional online stock trainings as well as other advanced training techniques such as Cash Flow Options, Spread Trading, Hedging and Institutional Tactics and Strategies, and more. For complete information on all the advanced financial investment training Rich Dad Education provides, you are encouraged to call 1-866-890-7608 toll-free and speak to one of our advisors. We wish you success!

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Rich Dad Education 4255 Lake Park Blvd., Suite 300 Salt Lake City, UT 84120 Phone: 866-890-7608 www.RichDadWorkshops.com

2011 Rich Dad Education. All rights reserved. The Rich Dad word mark and logos are owned by Rich Dad Operating Co., LLC and any such use is under license. 11RDES0112 v1 7-11