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

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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 company’s 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 specic 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 one’s 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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OPTOS TA: T POW TO MA MOY  AY MAT  STUATO Many people have discovered the power o options. Their acceptance in everyday fnancial management is growing widely and they provide a nice compliment or the modern investment portolio. Options can become a very powerul tool in the hands o the educated investor. They give investors the opportunity to make money in any type o  market environment, regardless o whether or not the investor’s trading style is conservative or aggressive. And the versatility o options allows them to be used in a wide-range o 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 beneft rom a stock price rise without incurring the cost o  buying the stock outright. • You can create cashow using stock that you own.  You have probably heard o the inherent risks in options and have been told they are primarily used or speculation. But in reality, options can be conservative or very aggressive, depending on the orecast you have or the stock and the strategy you want to employ. In act, some o 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 . Beore you participate in options trading, you must develop a solid understanding o 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 o an overall investment strategy. We oer 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 o our option trades are combinations o stock purchases and options or option/option strategies to generate what is called “spread-trading.” This is

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what many oor traders and und managers use every single day. Strategies like straddle, bull call, and call ratio back-spread will become amiliar terms and second nature to you i you continue your fnancial training with Rich Dad Education™.

What Is an Option? An option is a contract that derives its value rom 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 timerame. The key idea here is that the owner o an option has a right, not an obligation. I the owner o the option does not exercise this right beore 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) o an option is obligated to ulfll the obligations (requirements) o the contract i the option is exercised. In the case o a Call option on stock, the seller has given someone the right to buy the underlying asset. The seller o the Call option will be obligated to sell the stock to the Call option owner i the option is exercised. The owner o the options literally has the right to “call” the stock rom you. With a Put option on a stock, the seller o the Put option has given the right to sell that stock to another party. The seller o the Put option is thereore obligated to buy the stock rom the Put option owner i the option is exercised. The owner o 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 amiliar with options. Have you purchased insurance as a saeguard against a fre in your home, an accident with your car, or large medical bills? Do you pay a premium or your house, auto, and medical insurance? Then you have purchased a type o option. The act is, options are a part o our everyday lie, and have valuable application in our trading and investing pursuits. Auto insurance, health insurance, and homeowner ’s insurance are all examples o Put options. These options transer the risk o loss  rom the owner o an

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

Leverage Options take advantage o leverage. Leverage is the term used to describe the proft or loss potential when a small amount o money controls a large amount o money. In the example o an option, the owner o one Call option has the upside potential o 100 shares by investing a smaller amount o money rather than purchasing the stock outright. I 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.

Let’s look at an example o the possible dierence in returns when purchasing the stock outright vs. purchasing the option. • Purchase 100 shares o stock @ $32 or a cost o $3,200. I the stock rises rom $32 to $42, you would have a $1,000 gain, or a 31% increase. • On the other hand, option or contract 100 shares o stock by purchasing the call at a premium o $3 per share or a cost o $300 (1 contract x 100 shares x $3 premium = $300). I the option premium rose rom $3 to $11, the original cost was $300 and it is now worth $1,100. You have an $800 proft, but a 266% return! When comparing the stock purchase to the option purchase, your stock purchase will have a moderately high dollar proft. But your option purchase can have a signifcantly 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 rom 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 o the option you purchased. Too many amateur investors or beginning traders do not take enough time to think about the potential downside beore  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 o options, we are no longer limited to the buy and hope strategy. We can now make money in any type o market situation. We can be very aggressive or we can be conservative, depending on our investing personality and objectives.

The Basics of Options Beore you actually start investing with and trading options, you need to understand the basic terminology (the language) o options and more about how they work. For example, you need to know the actors that aect the prices or premiums, and how that relates to the price o 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 specifc price on or beore a specifc date. And we have learned that there are two types o 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, let’s 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 o shares o the underlying stock at a specifed price (strike price) on or beore the date the contract expires (expiration date). A Put contract gives the buyer or holder o the contract the right to sell the underlying asset and gives the writer or seller o the contract the obligation to buy a set number o shares o the underlying asset at a specifed price (strike price) on or beore the date the contract expires (expiration date). A contract usually accounts or 100 shares o stock. However, i there has been a recent split in the stock, this may not be the case. The buyer o the contract will pay a premium. The writer or seller o a contract will collect a premium. Continue Your Financial Training With Us! www.richdadworkshops.com • 866-890-7608

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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 o the month (technically, it’s the third Saturday at 11:59 a.m.). • Premium – The cost o the option. Now, let’s take a look at an example o how these all relate together.

A Real-World Example  You are interested in building a gol course and have ound a great piece o land in a potentially high-growth area. You evaluate your situation as ollows: • 1,000-acre property in an area o potential rapid growth. • It will take time to get land permits, secure fnancing and deal with environmentalists. • You want to secure the land while you put everything in place. You also don’t want to purchase the land outright since it would be quite expensive and you may not get approval to build the gol course. Strike Price

• You go to the property owner and “strike” a deal that allows you to purchase the property or 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 or all 1,000 acres. The price that you agree to is called the strike price. I you are not successul in obtaining the right to build a gol course, you can just walk away rom the deal and lose only the amount it cost to purchase the contract.

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Expiration Date

• To oer some protection, the property owner inserts a clause that the contract will not be valid ater six months. • This creates an expiration date. The contract has an expiration clause written into it to protect the landowner rom being obligated to sell his property or an unreasonable amount o time. It will also decrease the cost o the contract to you because we will only be tying up the land or a short, predetermined amount o time. Premium

• The landowner will collect a premium or being obligated to sell us the land or 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 or being obligated to sell you the property. The amount o money he expects will be determined by how long he will be under obligation and what the expectations are or 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 or the contract no matter what. Second, the agreed upon sale price (strike price) is likely to be much higher than he could obtain i 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 transerred and the parties to the contract take obligations. Now, let’s learn a little bit more about the components o 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, i you see May 30

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Calls, this means you have the right to buy stock at $30 per share. I 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 ollows: • Stocks costing rom $5 to $25: Increments o $2.50 starting at $5 • Stocks costing rom $25 to $200: Increments o $5 starting at $25 • Stocks costing rom $200 to $60,000: Increments o $10 starting at $200

Expiration Date This is the month when the option contract will expire. For standard options, the dates can range rom one to nine months and expire on the Saturday ollowing the third Friday o the month. However, since you can’t trade on Saturday, the third Friday o the month is considered the option expiration date. I you see a quote or May 30 Calls, May reers to the expiration month and the actual expiration date will be the third Saturday o May. So, the option will no longer trade at the close o the markets on the third Friday o May, and will expire the next day. I 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 option’s price. It is the amount that the seller o the option will collect or taking on the obligation o 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 or 100 shares o stock. The premium or price is given or one share. I you see a May 30 Call at $4, the price or one contract is 100 shares multiplied by $4, or $400. (1 x 100 x $4 = $400). The premium is primarily aected by three things: • Time • The underlying asset price relative to the strike price • The volatility o 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

Week

Week

Week

4

3

2

1

The value o an option is highly dependent on the amount o time let beore the option expires. Options are considered “wasting assets” because they have a limited lietime and their value decreases as their expiration date approaches. Time value is the portion o the premium that is dedicated to time remaining until a contract expires. When buying time, the purchaser o an option is buying the possibility that the option value will increase beore the expiration date. As the option approaches expiration, its time value decreases toward zero. At expiration, the option’s value will be zero unless the option fnishes In-The-Money.

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

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Intrinsic Value I an option is ITM, it has what is called intrinsic value (value i it were to be exercised). Intrinsic value is the dierence between the stock price and the ITM strike price. In other words, it is the ITM por tion o an option’s price. For example, a stock is trading at $37.50 and the strike price on the option is $35, thereore, the intrinsic value in the option is $2.50. The general rule o option pricing is as ollows: • ITM options are more expensive, however, ITM options go up in value aster as the price o the stock goes up. • OTM options are less expensive, however OTM options go up in value slower as the price o the stock goes up.

Volatility One o the most important aspects in determining the value o an option is the behavior o the underlying stock. There can be many dierent opinions rom investors about how a stock might behave going orward. Individual option traders may also disagree about the value o any given option. That dierence o opinion can aect the price o the underlying security dramatically. This brings us to a concept called volatility . • Volatility is the measure o 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 o an option being ITM during its liespan. • This greater chance increases the price o the option.  Volatility o the underlying stock is a key actor in determining an option’s value. As the volatility o a stock increases, an option’s premium will usually increase. The difculty o predicting the behavior o a volatile stock allows the option seller to command a higher price or the additional risk. This is one advantage to Call and Put writers.

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Reading a Quote Screen Another key to moving orward 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 dierent, but the inormation on almost all quote screens is the same. Inormation o the underlying security and its perormance on the day is usually at the top o the screen. The options are then listed underneath. Calls will typically be listed on the let and Puts will be listed on the right. On a ew 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 frst three letters or spaces correspond with the underlying asset (note: the letters do not need to be the same). The ourth letter corresponds to the expiration month. And the last letter corresponds to the strike price. The Month Code comes rom this table: Expiration Month Codes Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Calls

A

B

C

D

E

F

G

H

I

J

K

L

Puts

M

N

O

P

Q

R

S

T

U

V

W

X

And, the Strike Price comes rom this table: Strike Price Codes A

B

C

D

E

F

G

H

I

J

K

L

M

5

10

15

20

25

30

35

40

45

50

55

60

65

105

110

115

120

125

130

135

140

145

150

155

160

165

205

210

215

220

225

230

235

240

245

250

255

260

265

305

310

315

320

325

330

335

340

345

350

355

360

365

405

410

415

420

425

430

435

440

445

450

455

460

465

505

510

515

520

525

530

535

540

545

550

555

560

565

605

610

615

620

625

630

635

640

645

650

655

660

665

705

710

715

720

725

730

735

740

745

750

755

760

765

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N

O

P

Q

R

S

T

U

V

W

X

Y

Z

70

75

80

85

90

95

100

7½

12½

17½

22½

27½

32½

170

175

180

185

190

195

200

37½

42½

47½

52½

57½

62½

270

275

280

285

290

295

300

67½

72½

77½

82½

87½

92½

370

375

380

385

390

395

400

97½

102½

107½

112½

117½

122½

470

475

480

485

490

495

500

127½

132½

137½

142½

147½

152½

570

575

580

585

590

595

600

157½

162½

167½

172½

177½

182½

670

675

680

685

690

695

700

187½

192½

197½

202½ 207½

212½

770

775

780

785

790

795

800

217½

222½ 227½

232½

242½

237½

 You do not need to memorize these, just know that this inormation is all very organized and this is typically what you will see when looking at an options quote screen. For urther help in reading a quote screen, additional inormation about the various felds is provided below. The Symbol will be the frst column. Be very careul to make sure you are entering the correct symbol or the contract you wish to buy or sell. When working with some quote screens, you will see a period in ront o 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 ollowing the symbol. Again, this is a computer programming related issue and is o 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 ew days ago and might not reect current market prices. The Bid is the highest price that any buyer is willing to pay or the option. When you are selling a contract, this is the price you will get or 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 o contracts that have been traded or that day. The Open interest is the number o contracts outstanding or open. It is considered to be a measure o how liquid a market may be. Liquid means how easy it is to buy or sell. The Strike is the specifc price o the option.

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Now that you understand some o the basic language and concepts o options, and have become amiliar with reading an option quote screen, let’s go over our key steps to making a proftable 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. Thereore, the frst step in making a proftable 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, i you think the price o the stock will go up, you will buy a Call option. On the other hand, i you think the price o the stock will go down, you will buy a Put option. 3. The third step is to estimate the strike price o the option. Determining the strike price involves looking at the ollowing: Intrinsic value – Remember, this is the value determined by the

relationship o 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 requent uctuations in stock

prices. Speculative value – Speculative value takes into consideration time

value, volatility o the market, and interest rates to measure the probability that an option will be worth more prior to the expiration date. 4. And the ourth step is to choose an expiration date that will bring the most proft potential. Remember that the higher the premium, the more time you need to earn a proft.

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The “"Options"“ Are Yours As we noted at the beginning o this report, options trading is a skill that is not recommended or beginning traders. Rich Dad Education™ oers 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 inormation on all the advanced fnancial investment training Rich Dad Education provides, you are encouraged to call 1-866-890-7608 toll-ree and speak to one o 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