The Option Advantage

THEOPTION ADVANTAGE 8 Reasons Options Work For The Smart Investor THE OPTION ADVANTAGE

CONTENTS

Introduction...... 3

Options Basics ...... 4

Option Advantage #1: Cost Efficiency...... 16

Option Advantage #2: Less Risk...... 24

Option Advantage #3: Better Returns...... 34

Option Advantage #4: More Ways to Profit...... 37

Option Advantage #5: Barriers to Shorting Stocks...... 46

Option Advantage #6: Ability to Generate Income...... 49

Option Advantage #7: Portfolio Protection...... 55

Option Advantage #8: Lock in Profits...... 61

INTRODUCTION Knowledge is having the right answer. about the risk management, cash efficiency, Learning is asking the right questions. leverage, and most of all, the possibilities that Before setting out to master the world are simply not possible by using stocks. Ask of options strategies, there’s one critical how they’ll benefit you. question you must ask: How do I benefit? It doesn’t make sense to spend time, effort, We have the answer: We call it the option energy, and money on anything if there’s advantage. no benefit for you.

It doesn’t matter that options strategies may WHY OPTIONS? be the safest way to profit in today’s markets. It doesn’t matter that options allow you to Fear and greed drive the stock market – but help defend against risk by hedging, rolling, for the wrong reasons. Fear makes investors and morphing. What matters is how options sell too soon, and greed makes them gamble will benefit you. their way from losing positions. Both are losing strategies. But options provide the Market Rebellion is an industry leading opportunity to control the amount of risk group of options professionals with you’re taking, help get better returns, become decades of experience – ranging from floor more cash efficient, and hedge positions for trading, market making, private investing, bigger future gains. It’s an edge we call the and individual coaching. We’ve got the option advantage. knowledge. As you read this book, think

OPTIONS BASICS Options are a class of financial assets Options are assets, just like shares of called derivatives. We know what stock, bonds, or mutual funds. They you’re thinking: Derivatives are risky trade on regulated exchanges with and should be avoided. After all, they bids to buy and offers to sell. Options caused the collapse of a Bank, and are legally binding contracts, just like nearly created a worldwide financial any business contract. Because of this, meltdown with Long-Term Capital options trade in units called contracts, Management. Well, not really. while stocks and mutual funds trade in units called shares. Options were used in these, and many other financial catastrophes. But it was What makes derivatives a little different the user, not the options, that was to from other assets is that their value is blame. In the hands of a skilled surgeon, tied to the value of something else. That nobody would say a knife is dangerous. “something else” is called the underlying However, if someone chooses to asset. For this book, we’ll focus only juggle machetes to get lots of attention on stock options, also called equity on Facebook, you can’t blame the options. However, you can buy and sell emergency trip to the hospital on the options on nearly anything including knives. Options are incredibly versatile commodities such as corn, oil, or and powerful tools, which is why the gold. You’ll find them on stock market traders behind these catastrophes indexes, real estate, foreign currencies chose to use them. They were trying to – even the weather. If the underlying get lots of attention on Wall Street – by has some number associated with it, an juggling machetes behind the back in option contract can be created. the dark. It wasn’t the derivatives’ fault. We want to show you a different side of While derivatives may sound scary, options – the option advantage. you’ve used them many times, just by

different names. For example, let’s say eventually buy the shares. Not true. you go to Walmart to buy an Apple While you can choose to buy the shares, iPhone for $500, but they’re sold out. most traders just trade the option The manager expects to have more contract back and forth in the market. back in stock in 30 days so gives you a How does that work? rain check, which gives you the right to buy one iPhone for $500 over the next Let’s say you sell this rain check to your 30 days. You’re not required to buy it, friend for $100. A few days later, the but you have the right to do so – it’s iPhone is selling for $700. Your friend your choice. Now let’s say this iPhone can do the same thing as you. He may becomes in great demand and the sell it to another friend for $200. He prices are quickly moving higher. Ten bought it for $100 from you, and sold days later, they’re selling for $600. it to another for $200. He doubled his money – and never had to buy Now it’s time to think like a trader: the phone. That’s essentially how all Let’s say you decided not to buy the derivatives work. Options traders never iPhone, would you throw away the rain take delivery of anything. Instead, they check? Of course not. You could sell it just buy and sell the pieces of paper – to another person who does want the the contracts – back and forth in the phone. If someone is willing to pay $600 market. for the phone, he’d love to have your contract that allows him to only pay Derivatives weren’t created as a $500. The contract is theoretically worth legalized gambling for the wealthy. the $100 difference. After all, you could They were designed to reduce risks use the rain check to and manage cash flows. Here’s another buy the phone for $500, example of a derivative you’re probably and perhaps sell it on used. Did you ever go to buy a puppy eBay for $600. The rain that wasn’t yet weaned? The breeder check has value because may say it’s going to be another six it locked in a fixed price, weeks before you can take it home. $500 in this example. But now there’s a risk to you and the As the phone price breeder. If you leave, your risk is that rises, so does the rain another person may end up buying it, check’s value. In other or that the price rises. For the breeder, words, the rain check’s the risk is that you walk away and he value is derived from never sells the puppy. He also risks the value of something else – it’s a falling prices. Perhaps other breeders derivative contract. That’s it. Derivatives announce in tomorrow’s paper that are nothing to be feared. They they have the same breed of puppies allow for people to safely negotiate for sale and there’s suddenly a price prices, manage cash flows, and more war. How do both of you solve your importantly, manage financial risk. respective problems? Derivatives. The breeder may say. “Give me $50 New traders are afraid of options down as a good-faith deposit, and the because they’ve heard you must dog is yours, but you can’t take delivery

for six weeks.” Your risk is removed and so is the seller’s. That’s a type of derivative contract called a forward agreement. Chances are, you’ve used many forward agreements in your life, just under different names. Derivatives are an essential feature of any well-developed market and are designed to make things easier. Financial options give you the same flexibility, great risk management and income- producing strategies. It’s the option advantage.

RIGHTS VERSUS OBLIGATIONS

One of the most fundamental principles of options is that it’s a market of rights versus obligations. It’s the simplest way to break the market down. If you buy an option, you’ll OPTION BUYERS pay money, but receive a right to do something. Option HAVE RIGHTS buyers have rights. Of course, for every buyer, there must WHILE OPTION be a seller. If you sell an option, you’ll receive money, but have an obligation to do something. Sellers have SELLERS HAVE obligations. As you continue to learn options, you’ll avoid OBLIGATIONS a lot of confusion if you always remember that buyers have rights and sellers have obligations. What are those rights and obligations? It depends on the type of option you’re using.

CALLS & PUTS – THE BUILDING BLOCKS

There are two types of options: calls and puts. These provide the building blocks for all option strategies. No matter how complex an option strategy may sound, it’s constructed with calls and puts. Not all stocks have options trading on them, but those that do are called optionable stocks.

If you buy a call option, you have the right to buy shares of stock for a fixed price over a given time – exactly like the rain CALLS AND check. It isn’t an obligation of any kind. If you’re not afraid PUTS ARE THE of a rain check, there’s no reason to be fearful of buying call BUILDING BLOCKS options. Call options get their name because you can “call FOR ALL OPTIONS shares away” from another trader. In other words, you’re choosing to be the buyer. Sometimes we may refer to the call STRATEGIES buyer; other times we may say the long call. In either case, it’s the same thing. The buyer is long the option.

Put options, on the other hand, give the buyer the right to sell shares of stock for a fixed price over a given time. No obligations of any kind are attached. Put options got their name because you can “put shares back” to another trader. It’s as if you’re saying, “Here ‘ya go, I don’t want my shares anymore. You take ‘em.” You’re forcing the transaction.

Notice that both the call and put In the financial markets, the word definitions are identical, except calls “long” means you bought the asset. allow you to buy while puts allow you You can be long shares of stock, bonds, to sell. or options. It just means you bought them. The word “short” means you’ve With options trading, you don’t have entered into the contract as the seller. to be the buyer. Anyone can buy, Throughout this book, we may refer to and anyone can sell. Depending on a call (or put) buyer or a long call (or your strategy, you may choose to be put). In either case, it means the same the seller. Remember – sellers have thing. Also, the short call (or put) means obligations! If you sell a call option, the same thing as the call (or put) seller. you have the obligation to sell shares The option seller can also be called the of stock for a fixed price over a given writer, much like an insurance company time. In exchange for accepting that writes a policy to accept obligations obligation, you’ll receive cash up front. in exchange for cash payments. We The call buyer pays money; the call can therefore say that long options seller receives the money. In our rain have rights while short options have check example, Walmart is acting as the obligations. The table below outlines call seller. Even though no money was the rights and obligations of the buyer exchanged like it would for an option, and seller. Notice that the seller’s Walmart was accepting the obligation to actions are exactly opposite of the deliver the phone for a fixed price – only buyer’s. If one side of the trade has a if you decide to buy it. It’s your right right, the other has the obligation. If or option to choose, which is where one side is buying, the other must be options get their name. The buyer has selling: the right to decide, while the seller must deliver. SIDE CALL PUT Buyer (Long) Right to Buy Right to Sell Seller (Shorter) Obligation to Sell Obligation to Buy EXPIRATION DATES For equity options, the last day to buy, sell, or exercise your option is usually For any optionable stock, you’ll find the third Friday of the expiration month. many expiration dates from which to Technically speaking, the expiration choose. The expiration date simply day is one day later on Saturday, but defines how long the contract is that’s for clearing purposes only. As good. For our rain check example, the a retail trader, you can’t do anything expiration date was in 30 days. For with your option on Saturday. Just be stock options, dates can be as little aware that some platforms or news as one week to nearly three years. services may show the option expiring The more time your buy, the more on Saturday. Your broker’s platform will expensive the option. show your last trading date so there’s no misunderstanding. Level Up Your Trading - CALL NOW: 866-443-8018 7 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

STRIKE PRICES (EXERCISE PRICES)

For each expiration date, you’ll find many fixed prices to choose from, which are called strike prices, or exercise prices. Thinking back to the rain check example, the $500 fixed price is the strike price – that’s where the deal was struck. It’s also called the exercise price because, if you choose to use the contract, you must surrender the contract in exchange for the phone. This is called exercising the contract, and $500 is the price you’d pay upon exercising. Take a look at IBM option quotes below:

SOURCE: OptionsHouse. Market Rebellion is not endorsed by or affiliated with OptionsHouse. For illustration purposes only. Not a trade recommendation.”

Across the top (red box) you’ll see the various expiration dates. Inside the red box, you’ll see a highlighted blue box for July 2017, which are the quotes we’re seeing. By clicking on the expiration month in the red box, you can jump to different quotes. In the vertical box in the center (green box), you’ll see different strike prices. Call option quotes are on the left while puts are on the right. For any given expiration month, the call and put sharing the same strike are called corresponding options. The $160 call’s corresponding option is the $160 put and so on.

IBM has far more strikes than shown above, and the platform allows you to adjust how many you’re seeing. Right now, it’s set to just show six, but if you select “all,” you’d see strikes ranging from $80 to $235. The reason for so many strikes is that each time the stock closes at new highs or lows, the exchanges create new strikes so there are always some near the current stock price.

For this expiration, IBM has strikes listed in five-dollar increments, but if you looked at shorter-term, they’d be listed on $2.50 increments. Depending on the stock’s price and expiration, you may see strikes listed in increments as small as 50 cents and as wide as $20.

BUYING CALLS move high enough to make up for this cost. Your true price is therefore $160 For any call or put, you’ll see a bid price + $4.35, or $164.35. This is the option’s and an ask price, also called the offer breakeven price. If you buy the $160 call price. For the most part, you can think for $4.35, you need IBM to be trading at of the asking price as the price you’ll pay $164.35 just to break even. To be clear, to buy the contract, and the bid price as you can exercise the call at any time for the price where you can currently sell. any reason. You don’t need IBM to be trading above $160 to exercise the call. The July 2017 $160 call has 85 days The breakeven point just shows where to expiration and asking $4.35, which you need the stock to be to get your means you can buy the call option for money back. The call option breakeven $4.35. However, because each contract formula is call price + strike price. Just controls 100 shares of the underlying, it as with the rain check example, most means you’re paying $4.35 per share * traders will never exercise the call. 100 shares, or $435 (plus commissions) Instead, they’re hoping to sell the call at to own the call. You’re not limited to a higher price in the future. just one contract. You could buy two contracts, which would cost $870. Ten SELLING CALLS contracts would cost $4,350 and so on. Regardless of how many contracts All call buyers need a seller. If you buy you buy, once you pay the price, it’s an IBM call, someone had to sell it to the most you can lose, which is a great you. You can sell options just as easily risk-management tool. To compare, if as you can buy them. When you sell an you bought 100 shares of IBM, it would option, however, you don’t get a right cost $16,000 and there’s no way you’re – you have an obligation. However, if guaranteed to contain your losses to you sell any option, you don’t have the just $435 – even if using stop orders. limited risk benefit that buyers have. That’s because you have an obligation If you pay $4.35 for this call, you have to deliver, and there’s no telling how the right, not the obligation, to buy 100 much that obligation will be worth in shares of IBM for $160 per share at any the future. time through the expiration date in July. In other words, you have the right to The IBM quotes show the July $160 call decide if you’d like to exercise the call is bidding $4.15. If you choose to be and pay the $160 strike * 100 shares, or the option seller, you’ll receive $4.15 * $16,000. No matter how high the stock’s 100 shares per contract, or $415 cash. price may rise, you’re guaranteed to As a rough rule of thumb, you’ll have be able to purchase the shares for the to post a margin deposit of roughly fixed price of $160. 25% of the total contact’s value. In this example, the $160 strike * 100 shares However, if you do exercise the call, per contract is $16,000, so you’d have notice that your total purchase price to deposit about $4,000 to hold this isn’t really $160 since you paid $4.35 short position. to buy the call. You need the stock to

In exchange, you’ll have the obligation The IBM July $155 put is asking $3.05. to sell 100 shares of IBM for the If you buy this put, you’ll pay $305 and fixed price of $160 between now and have the right to sell 100 shares of IBM expiration if the long call exercises. for the fixed price of $155 – no matter In options lingo, if the long position how far the stock price falls. Put options exercises, the short position gets need the stock price to fall to make up assigned. It’s up to the long call buyer for the cost, so the breakeven formula to make that choice for you. That’s is put strike – put price, or $155 - $3.05, why selling a call creates an obligation. or $151.95. If IBM falls to $151.95 at However, you can always get out of expiration, you’ll just break even on t this obligation buy buying the contract he trade. back at any time. Of course, it’s up to the market to determine that price, so your purchase price may be higher – in SELLING PUTS some cases a lot higher – than your selling price. Just like a call buyer profits Just like calls, all buyers need a seller. from buying low and selling high, you’re You could choose to be the put seller hoping to sell high and buy the contract just as easily as being the buyer. You back low, which would yield a profit. could sell the IBM July $155 put and The breakeven point for the call seller is receive the $3.05 bid, or $305 cash total. identical to the call buyer. In exchange, you’d have the obligation to buy shares for the fixed price of $155 If you sell a call by itself, it’s called an per share if the long put exercises. It’s uncovered or naked position. We don’t up to the long put buyer to make that ever advocate selling naked options, no decision, which is why it creates an matter how enticing the opportunity obligation to the seller. The put seller’s may seem. Just understand that when breakeven is identical for the put buyer. selling options, we’ll always have it paired with another option (or shares of Just like naked calls, we don’t ever stock) in a way that limits risk. For this advocate selling naked puts. You will, book, however, we’re just focusing on however, hear many services that do long options – options you buy. because the odds seem so far in your favor, so why not take the apparently free money? For example, you may BUYING PUTS think there’s no way IBM will fall below $150 in July, so you sell the July $150 put Put options work the same way as calls, for $1.68. In fact, you’re so confident, except in reverse. We often tell students you sell 10 contracts and instantly it’s like driving in the northbound lane collect $1,680 cash to your account. versus the southbound lane. All the Seems like free money – until IBM rules are the same, the exits are the announces a bad earnings report, which same, and the speed limits are the sends the stock plummeting to $130. same. There’s no difference – except the That put is now $20 in the money – and direction. Call options profit when stock you must either buy it back at a higher prices rise, but put options profit when price, or take the assignment. If you buy stock prices fall. it back, it’ll cost $20,000. Level Up Your Trading - CALL NOW: 866-443-8018 10 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

If you take the assignment, you’ll receive However, the market priced the call stock worth $130, but pay $150 for it. to be far more than $5.28. There’s an Either choice leads to a $20,000 loss. It’s extra $7.45 - $5.28, or $2.17 worth of strategies like these that caused most value. That’s the extrinsic value. To find of the financial meltdowns you’ve read an option’s extrinsic value, you must about. Don’t ever sell naked options – always first figure out the intrinsic value no matter how confident you are. There and then subtract it from the option’s are better strategies. price. Extrinsic value exists because there’s time remaining on the option, INTRINSIC & EXTRINSIC VALUES and IBM’s price could rise more thus making the contract more valuable. All option prices can be broken down Traders are willing to pay for that time. into intrinsic and extrinsic values. One of the most important points to It’s important to understand these remember about options is that they two terms as they form the basis for lose 100% of their extrinsic value at deciding on which strikes to use in every expiration. With no time remaining, the options strategy. value of time is zero. However, if any option has intrinsic value, it retains that Intrinsic value is easy to understand. amount at expiration. It’s the amount of “real” or “immediate” value currently found in the option. Extrinsic value is the only value that IBM is trading for $160.28, so let’s think decays over time. Intrinsic value does about the July $155 call. If you buy not. the $155 call and the stock is $160.28, isn’t there an immediate benefit being If IBM remains at $160.28 at expiration, conveyed in that strike? If you owned the $155 call is worth $5.28. It will that call, you could exercise it, pay $155 only lose $2.17 from the passage of for the shares, and immediately sell time. The only way for the call to be them in the open market for the current completely worthless is if IBM falls to price of $160.28. There’s $5.28 of real $155 or lower at expiration. If you’ve value in that option. That’s the intrinsic heard that all options expire worthless, value. you now see it’s not true. If there’s any intrinsic It may seem that it’s also free money, so value, it always why not do that strategy all day long? remains with Let’s buy the $155 call, exercise it and the option. ALL OPTIONS flip the shares. The reason that doesn’t LOSE 100% OF work is that the market prices all For puts, the options to be worth at least the intrinsic idea’s the THE EXTRINSIC value. The market knows that the $155 same, just in VALUE AT call must be worth at least $5.28, so the opposite EXPIRATION, BUT without even looking at the quotes, we direction. If THEY RETAIN ANY know the option must be trading for at least that amount. After checking the INTRINSIC VALUE quotes, the $155 call is worth $7.45, so there’s no free money. Level Up Your Trading - CALL NOW: 866-443-8018 11 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

you buy the IBM July $165 puts, you worth $3.05 intrinsic value, which is the have the right to sell shares for $165 amount you paid. You just broke even. – even though they’re only worth $160.28. There’s an immediate benefit To figure any option’s intrinsic and being conveyed in this option, so it has extrinsic values, the process is easy: intrinsic value in the amount of $165 Always ask if there’s an immediate strike - $160.28 stock price, or $4.72. benefit, or an immediate advantage, We know that option must be trading conveyed in the option. If yes, it has for at least $4.72 and the quotes show intrinsic value, which is equal to the size it’s $8.05. So again, no free money. of the advantage. Any remaining value The additional value of $8.05 - $4.72 is extrinsic value. If there’s no intrinsic is $3.33, and that’s the extrinsic value. value, the option’s price is entirely If IBM stays at its current price at extrinsic value. expiration, all time value is erased, and the $165 put would be worth its $4.72 intrinsic value. IN, AT, AND OUT-OF-THE-MONEY

What about the $165 call? It gives Options can be classified as in-the- you the right to pay $165 for shares money (ITM), at-the-money (ATM), currently worth less than that. Doesn’t and out-of-the-money strikes (OTM). sound like much of a deal, does it? Sometimes you’ll hear these terms That’s because there’s no intrinsic called the option’s moneyness, and value. This option is made up entirely of they’re created to easily describe the extrinsic value. Because it’s trading for relationship of the option strike prices $2.17, this option will expire worthless to the stock’s price. You may hear a unless IBM is above $165 at expiration. trader say, “You should buy an in-the- The stock price must move higher by money call” for that strategy, or “sell expiration; otherwise, it’s a 100% loser. the at-the-money strike to get the most The breakeven point is $165 + $2.17, extrinsic value.” To succeed with options or $167.17. If IBM reaches that price at strategies, it’s important to understand expiration, the $165 call is worth $2.17 these relationships. intrinsic value, which is exactly the price you paid. You just broke even. The easiest one to figure out is the at-the-money strike. The textbook Now let’s try the $155 put. It gives definition says this strike exactly you the right to sell for $155. But IBM matches the current stock’s price, is trading for far more than that, so whether we’re talking about calls or there’s no immediate benefit in that puts. In the real world, it’s unlikely to option. There’s no intrinsic value, and find a strike that’s trading for exactly the options entire $3.05 price is made the stock’s price. And if you do, wait a up of extrinsic value. The breakeven few seconds. For practical purposes, point is $155 - $3.05, or $151.95. If IBM we define the at-the-money strike as doesn’t fall below $151.95 at expiration, the one closest to the stock’s current this put loses 100% of its value. If IBM price. Since IBM is currently trading for falls to exactly $151.95, the $155 put is $160.28, the $160 call and the $160 put

are at-the-money options. Technically $175 puts are in the money. speaking, the $160 call is ever-so-slightly in the money and the put is ever-so- If you like formulas, the following chart slightly out-of-the-money. It doesn’t may help: matter. They’re the closest strikes, so they’re at the money. RELATIONSHIP CALLS PUTS In-the-money strikes are almost as easy to identify. If an option has intrinsic Stock > Strike ITM OTM value, it’s in the money. It’s easy to Stock = Strike ATM ATM remember by connecting IN-the-money with IN-trinsic value. Finally, if it’s not Stock < Strike OTM ITM an in-the-money or at-the-money option, it’s out of the money. All out-of- STRATEGIC USES OF STRIKE PRICES the-money option prices are made up New traders often wonder why anyone entirely of extrinsic would ever buy an in-the-money option. BY USING value. They have no If IBM is around $160, why buy the DIFFERENT intrinsic value. $150, $145, or $140 strikes? It seems STRIKE PRICES, like you’re just dumping a lot of money YOU CHANGE A helpful into the intrinsic value, and therefore relationship to taking a greater risk if the stock moves THE RISKS AND understand is against you. Looks can be deceiving. REWARDS that any in-the- money call must There’s a mathematical relationship be matched with that’s vital to understand for strategies. an out-of-the- The more ITM the strike, the more money put and vice versa. Recall that intrinsic value, but the less extrinsic for any expiration month, the call value. It’s the extrinsic value that and put sharing the same strikes are creates higher breakeven points for call corresponding options. If the $155 (and lower for puts). Whether calls or call is in the money, its corresponding puts, greater extrinsic value requires option – the $155 put – must be out of the stock to make bigger moves, or a the money. “need for speed” – and that’s where the risk lies compared to the stock. To summarize: For calls, any strikes below the current stock price are in-the- In fact, it can be shown mathematically money strikes (ITM) while any strikes that if the exchanges created a call above are out-of-the-money (OTM) option with a zero-strike price and strikes. For IBM, the $150 and $155 no expiration date, it would trade calls are in-the-money strikes. For puts, for exactly the price of the stock. The it’s the opposite. All strikes above the pattern is clear: As you increase the current stock price are in the money, strike prices, call options prices get while all strikes below are out of the cheaper, but you need the stock price money. For IBM, the $165, $170, and to move higher before you’re profitable

current stock price. It’s two cents away because that’s the extrinsic value that must be made up by future stock price movements. Contrast this with the $160 call trading for $4.35 that needs IBM to rise to $164.35 just to break even. There’s a very good chance IBM will increase by two cents before expiration thus providing profits to you. The same can’t be said about the $160 call.

Out-of-the-money strikes have no intrinsic value, but they also have small amounts of extrinsic value. Because they’re OTM, however, their breakeven points are pushed even higher. The IBM at expiration. As you decrease the call July $170 call is trading for about one strikes, you’ll pay more for the options, dollar. It’s all extrinsic value, and will but the stock won’t need to move as expire worthless unless IBM can climb far to break even at expiration. They’ll above $170. You’d need the stock to get behave more like shares of stock. above $171 – just to get your money back. There’s a slim chance for that to The opposite is true for puts. Higher- happen by expiration in 85 days. strike puts behave more like short shares of stock and don’t need the stock Always remember that ATM options to fall as far before becoming profitable. carry the greatest amount of extrinsic Lower-strike puts are cheaper, but they value. As you move further ITM or also require the stock to fall further further OTM, the extrinsic values get to make money. All option strikes are smaller. ITM options behave more like tradeoffs in risk and reward. the underlying stock (ITM puts behave more like short shares) while OTM For example, even though it’s not options are like a long-shot lottery shown in the IBM quotes, the July $120 ticket. This doesn’t mean we never use call is trading for $40.30. With the OTM options. They can be great to sell stock at $160.28, that’s $40.28 cents of against other positions. And in the right intrinsic value, and only two cents of circumstances, they can be good to extrinsic value. The reason the extrinsic buy. It all depends on how they’re used. value shrinks is that the option is But in all cases, you’ll find the option shaping up to be nearly guaranteed to advantage. Let’s find out why. be exercised by someone at expiration. If there’s nearly a 100% chance for that to happen, the option is mathematically behaving far more like shares of stock, and less like an option. That’s why the breakeven price of $120 + $40.30, or $160.30 is only two cents away from the Level Up Your Trading - CALL NOW: 866-443-8018 14 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

1 OPTION ADVANTAGE #1: COST EFFICIENCY

Every trader knows the secret to making more shares, they’ll get a big advantage. money in the market: Buy low, sell high. Mathematically, however, the number But “low” is a relative term. Just because of shares you own has nothing a stock’s price may be reaching the to do with your returns. It seems point of a screaming good deal, it still counterintuitive, but an example shows may require a large chunk of cash to why. Say that Tiny Tech is trading for capture the opportunity. The common one dollar per share while Giant Growth cry of stock traders is “I knew it was is $100 per share. If you have $10,000 going to go up, I just didn’t have to invest, you could buy 10,000 shares the money.” of Tiny, but only 100 shares of Giant. It seems like you’re better off with Tiny, It’s a common problem because stocks as each dollar it rises puts $10,000 into can get expensive. The problem is your pocket rather than the $100 you’ll compounded once you understand get with Giant. that the highest-performing stocks will naturally come with high price tags – The mistake falls in assuming Tiny has everyone’s buying, and few are selling. the same probability of moving one Just look at Amazon.com (AMZN) at dollar as Giant. It appears that stock $900, Priceline.com (PCLN) at $1,800, prices move in dollars, but they actually and even Chipotle Mexican Grill (CMG) move in percentages. For Tiny to move at $500 – that’s the price per share. one dollar, the company’s value must double. For Giant, a one-dollar move is If you buy 100 shares of Priceline only one percent, which is nothing at all. because you think it will jump $30 in It could easily be a spill-over effect just the next month, you laid out $180,000. because the S&P 500 is up. The same If you’re right, you made $3,000, or less one-dollar move for Tiny is staggering, than a 2% return on your investment. while for Giant it’s nothing. When It’s not much considering that you were comparing stock price changes, always on the hook for potentially a much look at percentages. bigger loss. Better to just let that one pass you by. So let’s use percentages and see if the number of shares matters. If both Despite all the wonderful fire-sale companies do equally well and increase prices the analysts may be talking about 20% at the end of the year, Tiny would on CNBC, they may as well be talking be trading for $1.20 and Giant would be about a Labor Day sale at a Rolls-Royce worth $120. Your 10,000 shares of Tiny dealership. It’s not going to make a and 100 shares of Giant are both worth difference if you can’t participate. $12,000. Regardless of which stock you bought, your investment performance is High-priced stocks pose another identical – a 20% increase. The number problem. Retail traders turn to cheap of shares has nothing to do with your stocks thinking that, if they can buy returns. Instead, it was the stock’s

performance. Notice that the number Once you buy the call, the most you of shares never enters the calculation can lose is $565. That’s a big advantage for performance. Instead, it’s the because it’s a 100% well-defined risk percentage change from your purchase that never changes. If you bought 100 price to your selling price. If Tiny and shares of Apple for $14,500, there’s no Giant increase 20%, both trader make way you could guarantee your losses 20% on their money regardless of the wouldn’t exceed $565 – even with number of shares owned. stop orders.

As investors, the decision on which Let’s say Apple rises $10 to $155. At stock to buy should never be based expiration, and the call option is worth on price. Instead, it should be based exactly the $10 intrinsic value. You paid on which one has the best chance of $5.65 for the call and can sell it for $10. increasing (for a given level of risk). You The call allowed you to profit from a should always invest in the stock’s you rising stock price because you locked in like best. But now you’re caught in a your purchase price at $145. If the stock Catch-22: You don’t have a lot of money rose $10 prior to expiration, the $145 to invest, but the best stocks usually call would have to be worth at least $10 come with high price tags. How do you because there’d also be some extrinsic solve the problem? value attached to it. Remember, the further ITM the call climbs, the less You need cost efficiency. You extrinsic value there’ll be. need options. If you wanted to own the shares, you When you buy a call option, you’re not could exercise the call and take delivery buying equity. You’re not paying for all of 100 shares. You’d pay $145 per share past cash flows that brought the stock for stock currently worth $155 and have to its current price. Instead, you’re just a $10 “paper gain,” or unrealized gain. buying the right, not the obligation, to Either way, it’s $10 to you. buy shares at a fixed price in the future. However, because you have the right There is, however, a big risk with to buy shares for a fixed price, you’ll exercising because there’s no guarantee capture all future stock prices above the stock’s price will remain at $155. that level – just as if you owned the By exercising calls, you’re right back shares – but for a lot less money. into the risk of holding shares. That’s why most traders just buy and sell the For example, it’s now April 2017, and calls in the open market and never take let’s assume you think Apple Computer delivery of the shares. is poised for big run over the next three months and is currently trading for By purchasing this call, you’re $145. Apple currently has August 2017 controlling $145 stock for $5.65. As a call options with 115 days to expiration. percentage, you’re paying $5.65/$145, The ATM $145 call is trading for $5.65, or about 4% of the stock’s price. That’s or $565 total. 25:1 leverage. That’s cost efficiency.

However, as we’ll see shortly, this Compare that to the ATM $145 call that isn’t the bad type of leverage that needs the stock to rise to $145 strike + you get when you borrow money to $5.65, or $150.65. buy shares on margin. Instead, it’s a mathematical leverage created since In options trading lingo, in-the-money you’re not spending the strike price calls have higher deltas, which is a today. Instead, you’re floating that mathematical sensitivity to shares of amount through expiration. In other stock. The $125 calls currently have a words, the stock trader must pay the delta of 0.87, which means it’s behaving full $145 today. The option’s trader pays like 87 shares of stock right now. If the $5.65 today, but has the choice to pay stock price were to instantly rise one the remaining $145 in the future. The dollar, this option’s price would increase strike price is mathematically a form of by 87% of that amount, or 87 cents, borrowed money – but without actually from $20 to $20.87. As expiration gets borrowing. closer, provided the stock stays above the $125 strike, this option’s delta will Options, however, give you choices. move toward 1.0, at which point it’s That’s part of the option advantage. acting exactly like shares of stock. A You don’t have to trade the ATM strike, delta of 1.0 means the option’s price will which is rich with extrinsic value. In rise and fall dollar-for-dollar with the many of our trading services, we often stock – it’s acting exactly like the shares. use the Stock Replacement strategy, A delta of 0.87 means it’s acting a lot which is the use of deep-in-the-money like the shares, just not perfectly. But it’s calls as a substitute for the shares. still a great substitute or “replacement” Rather than using the $145 calls, for for the shares. example, what if we used the August $125 calls trading for $21? Notice, however, even though the $125 call costs $21 compared to $5.65 for With the stock at $145, the $125 calls the $145 strike, it’s still only $21/$145, are $20 in-the-money, or $20 worth or 14% of the stock’s price, or 7:1 of intrinsic value. Because the option leverage. This leverage number roughly is trading for $21, however, that extra means that for every percent the stock dollar is extrinsic value. Remember, price rises, your returns will be 7-times as you move to deeper-in-the-money greater. For instance, if the stock rises calls (select lower strikes), you’re paying 10% to $158.40, the $125 call is worth more for intrinsic value – but less for $33.40 at expiration – a 67% increase, extrinsic value. The lower extrinsic value which is roughly 7-times the 10% reduces your expiration breakeven move. The reason it’s not perfect is the point, and that’s what makes the option extrinsic value. behave more like shares. With the $125 calls, you only need the stock to rise to Most new traders think $21 is a lot to $125 strike + $21, or $146 by expiration pay for an option. Once you understand to break even. With the stock currently the role between intrinsic and extrinsic trading for $145, that’s only one dollar values, you’ll see the intrinsic value acts away – the amount of the extrinsic like a down payment on the shares. value. Level Up Your Trading - CALL NOW: 866-443-8018 17 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

To see why, assume Apple falls from $50,000 to invest may only be able to $145 to $125 and you lose the entire buy shares in three or four different $21 on the call. Would you have been stocks. By using better off buying the stock? With the options, he stock at $125, the stock loses $20, so might control not much better off. The additional 10 or 15 OPTIONS ALLOW dollar lost by the option is the extrinsic different stocks YOU TO SPEND value. By keeping the extrinsic value – LESS MONEY BUT low, it makes the option behave more and still have CONTROL THE like the actual shares. So why pay the cash left over. extrinsic value at all? Why not stick With more SAME NUMBER with the shares? Because the option stocks in the OF SHARES provides downside protection. If the account, there’s stock falls to $120, the option trader a better chance loses $21, but the stock trader loses of picking the $25. If the stock falls to $100, the option next big winner, and a smaller chance trader still loses $21, but the stock you dumped all your money into one of trader loses $45. See what’s happening? the Dogs of the Dow – with fleas. The option limits the downside losses, while the stock trader continues to take Extra cash also allows you to capture losses for all prices below the strike spur-of-the-moment opportunities. – all the way to zero. The option is an You never know when a stock may gap insurance policy against losses, and down 30% on the opening bell because that’s why we pay the extrinsic value. of a bad earnings report. Often, you’ll By using options that are deep-in-the- hear CNBC analysts saying it’s a great money, you’re more closely trading the opportunity and buy all the shares shares compared to trading an option. you can, which poses a problem if No matter which strike you buy – ITM, you have no cash. By having cash on ATM, or OTM – you’ll always spend less hand, you won’t have to predict when than what you would have spent on the opportunities will arise. Instead, you’ll shares. That’s cost efficiency. react to them. It’s easy when you’re dealing with cash-efficient options. MORE CASH – MORE DIVERSIFICATION SYNTHETIC DIVIDENDS Having additional cash creates another Cost efficiency provides another interesting benefit. Options traders benefit – diversification. Because you’re can create a synthetic dividend, which spending less for options, you’ll have is a way of mathematically creating a more cash in the account, which can be dividend – even if the stock doesn’t pay used for other stock picks. You could one. For instance, Chipotle Mexican also choose to use that cash to buy put Grill (CMG) is trading for $483 and pays options as a form of insurance, whether no dividends. If you wanted to buy 100 against certain stocks, or the entire shares, you’d spend $48,300. Instead, portfolio. For example, an investor with you can buy the $440 call for $70, or Level Up Your Trading - CALL NOW: 866-443-8018 18 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

$7,000 per contract. With a delta of 0.80, an options trading account, you must this call will behave reasonably close have a margin account. However, just to shares of stock – but at a fraction because you have a margin account, of the cost – just 14% of the stock’s doesn’t mean you’re using margin. It price. Rather than spending $48,300 just means you have the ability to. Think for the shares, buy the $440 call for of it like opening a credit card; it only $7,000 and keep the $41,300 balance counts if you’re using it. in cash. Each month, your broker pays interest on the $41,300 money market Stock traders can gain leverage by balance, and those interest payments purchasing shares on margin, which act like dividends. Most dividend-paying means you deposit 50% of the total stocks pay quarterly, but with synthetic purchase price (subject to a $2,000 dividends, you’re getting paid monthly. minimum) and automatically borrow Cost efficiency opens benefits most the balance from the broker. The 50% investors never consider. deposit is called the Reg T amount, short for Regulation T, which was established by the Federal Reserve THE UNCERTAIN WORLD OF Board that governs the extension of MARGIN TRADING credit by brokers.

Because of the cost efficiency, options In exchange, you’ll pay monthly interest open the doors for many advantages. on the borrowed funds. For instance, Sometimes stock investors counter to buy 100 shares of Apple on margin, by saying they can do the same thing it would cost $14,400, so you’d deposit by using margin. Margin trading is an $7,200 and borrow the remaining entirely different form of leverage, $7,200 from the broker. All you have and it doesn’t provide anywhere near to do is buy the shares and the rest is the amount of cost efficiency. To fully automatic, provided you have a margin appreciate the option advantage, account. it helps to understand how margin trading works, and why it’s not a Each month, your account will be substitute for options. debited for the interest due on the borrowed $7,200. As expected, the To buy or sell interest rates are far higher than stock on margin, market rates. For instance, right now in you must early 2020, a one-year Treasury bill pays BECAUSE have a margin about 1.5%, but a broker may charge OPTIONS ARE account, which 5% interest. Most brokers offer a sliding scale where the rates decrease the CASH EFFICIENT, is as simple as filling out a more you borrow. Regardless, it’s a lot, YOU CAN GET margin trading considering the loan is highly secured ADDED LAYERS OF agreement and since you’ve paid for half the position. DIVERSIFICATION can usually be done online. In By using margin, you’re controlling order to open $14,400 worth of stock for only 50% down, or $7,200, and you’re gaining Level Up Your Trading - CALL NOW: 866-443-8018 19 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

2:1 leverage. It’s a far cry from 4% and Let’s say the stock makes a quick 10% 25:1 leverage we got with the $145 move up to $15,840: call. However, there’s a bigger problem with margin trading. If the stock price Market Value = $15,840 falls, it reduces your equity. Most - Margin Balance = $7,200 brokers allow your equity to fall to 30% = Equity $8,640 before requiring you to deposit more money, which is called a margin call Your equity increased from $7,200 (or maintenance call). The formula to to $8,640, or 20%. A 10% stock move understand is Market Value – Margin resulted in a 20% increase in your Balance = Equity. equity. That’s the 2:1 leverage at work. Your equity is now $8,640/$15,840, or For example, if you buy 100 shares of 55%. However, leverage is a double- Apple on margin for $144, the market edged sword and cuts both ways. If value of those shares is $14,400. The the stock price falls 10%, your equity amount you borrow is the margin falls 20%. However, if the stock price balance, also called the debit, is $7,200. falls too far so that your equity is below The difference is your equity: 30%, you’ll receive a margin call, or maintenance call. Let’s say the stock Market Value = $14,400 price falls 28% to $102.85: - Margin Balance = $7,200 = Equity $7,200 Market Value = $10,285 - Margin Balance = $7,200 When the trade is first placed, your = Equity $3,085 entire equity comes from your initial margin deposit. Equity is what’s left over Your equity has now fallen to after you pay off the debts, or “what $3,085/$10,285, or 30%. This is the you own minus what you owe.” You critical maintenance level. (Based on “own” $14,400 worth of stock but “owe” New York Stock Exchange rules, you $7,200, so your equity is the $7,200 can technically go to a minimum of 25% difference. equity. However, brokers can make any rule stricter, so most use 30% as Another metric the brokers watch is an added cushion.) If the stock drops the equity percent, which is found by any more, your equity will fall below dividing your equity by the market 30%, and you’ll receive a margin call value, or $7,200/$14,400 = 50%. All from your broker. You’ll have to deposit margin trades begin at 50% equity. How at least enough money to bring your does your equity change? equity above 30%. Of course, if you just bring it just up to 30%, you may get The margin balance remains fairly another margin call tomorrow, so most constant over time, except for monthly traders bring it up to 35% or more. interest that gets tacked on. However, You can calculate this value by taking the driving force of your equity is the your margin balance and dividing by stock’s market value. As the stock’s the (1-margin level). In this example, market value rises, it increases your the margin level is 0.30, so 1-0.30 is equity. 0.70. Take $7,200/0.70 and you’ll get Level Up Your Trading - CALL NOW: 866-443-8018 20 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

$10,285 market value. Most platforms possible you’ll have to send in more will show this to you, but it’s worthless money. There’s no telling when or how information unless you know what it much. Margin trading creates a cloud of means. uncertainty hanging over your head. It is not a substitute for trading options. Most brokers allow you to meet the maintenance call by close of business When using options, you know with that same day. Here’s another big risk 100% certainty that the most you can most traders don’t know about. If you lose is the amount you spent. There will don’t meet the maintenance call, the never be a margin call – ever. You get broker can sell any securities to meet mathematical leverage by floating the that call. It doesn’t have to be the shares exercise price through to expiration, but creating the problem. The reason is that you’re not physically borrowing money clients borrow individually, but brokers and putting yourself in a situation lend collectively. The brokerage firm where you may owe even more money always closes the shares that pose the if the stock moves against you. biggest risk to it! So even though you may find that you’re out of maintenance tomorrow, you may find yourself right back in it the next day since the broker ANOTHER RISK sold different shares to meet the OF MARGIN margin call. TRADING IS THAT That’s why it’s crucial for traders CLIENTS BORROW to handle their own maintenance INDIVIDUALLY, calls. That’s easier said than done. If BUT BROKERS you see you’re about to hit the 30% LOAN maintenance level (or whatever level your broker uses) it’s human nature to COLLECTIVELY hold on and hope the stock bounces. Nobody wants to press the “sell” button and instantly lock in a huge loss. The fear of regret kicks in. You’ll convince yourself the stock will bounce higher tomorrow after all the selling pressure subsides. The inclination to hang on and hope is too strong, and traders end up digging bigger holes. That will never happen with an option. The option automatically hedges that risk for you, whether you want it to or not. That’s an option advantage.

The key point to understand is that by trading on margin, it’s always a

To see the option advantages, let’s compare two traders: One buys the Apple $125 call while another buys 100 shares on margin:

POSITION BUY ONE APPLE $125 CALL BUY 100 SHARES APPLE ON MARGIN Amount you pay $2,000 $7,500 Maximum loss $2,000 $14,400 Maximum gain Unlimited Unlimited Leverage 7:1 2:1 Cash saved $12,400 $7,500

After looking at the above chart, if you’re wondering why anyone would ever buy the shares, congratulations, you’re understanding the first option advantage of cost efficiency. By trading options, you’ll always spend less money than you’ll spend on the shares. Trading on margin creates some leverage, but it opens the door for losses to be far greater than your initial investment, and creates uncertainty about future maintenance calls. If you buy an option, your leverage is much greater, your maximum loss is smaller and known up front, and you’ll remove all risk of ever having a maintenance call. If you’re impressed with options right now, we’ve only wrapped up the first advantage.

ANOTHER RISK OF MARGIN TRADING IS THAT CLIENTS BORROW INDIVIDUALLY, BUT BROKERS LOAN COLLECTIVELY

2 OPTION ADVANTAGE #2: LESS RISK

You’ve probably heard that options are should. The captain goes down with riskier than shares of stock. The reality the ship. If we graph the various profits is that it depends on how they’re used. and losses that could occur with shares If the stock is $100 and you buy OTM of stock, it forms a straight line. For options, say the $105 call, then it has a instance, assume you buy 100 shares high probability of expiring worthless for $100, your profit and losses look like and is considered riskier. The option is the following diagram: made up entirely of extrinsic value and acting more like a lottery ticket rather Long Stock at $100 than shares of stock. $30

However, what if the stock is $20 announcing earnings tomorrow and $10 you thought it may make an enormous move if the news is good, but could $0 80 85 90 95 100 105 110 115 120 take a significant hit if it’s not. Well, if Loss Profit/ $-10 that $105 call is trading for $2, it allows you to participate to all stock prices $-20 Stock Prices above $105, but limits your losses to $2. The main thing to understand is that $-30 all options – calls and puts – limit the amount of money you can lose if The horizontal axis shows various stock you’re wrong. prices, while the vertical axis shows the various profits or losses. Notice how However, if you’re using ITM options the blue line crosses the horizontal axis such as we use for our trading services at zero – that’s the breakeven point. or many others, you’re using insured In other words, if you pay $100 for the shares of stock. The option’s extrinsic shares and sell them for the same price, value acts like an insurance policy. you won’t make money and you won’t There are times for using ATM or lose money – you just broke even. If possibly OTM, but for most investing, the stock rises to $105, you’ll make $5, focus on using ITM options, as they’re which is where the graph lines up with just insured shares of stock. the vertical axis. If the stock falls to $80, you’ll lose $20 and so on. The main Stock, by itself, carries heavy risk. If you point to see is that the profit and loss buy shares of stock, you’re part owner diagram for long shares of stock always of the company. On the good side, you plots as a straight line. You can make can earn dollar-for-dollar forever as the 100% of all future stock price increases, stock price rises. It’s the downside you but will lose 100% of all decreases. By have to watch out for. If the stock price investing in shares of stock, it exposes falls, you’ll take dollar-for-dollar losses you to extreme outcomes, and one of all the way down to zero, as any owner the best rules of risk management is

to avoid extreme outcomes: Don’t bet the shares. Instead, just let it expire it all if it means you can lose it all. But worthless and take the loss. If you that’s what you’re doing with shares of really want the shares, just buy them stock. It’s the unlimited downside that for less money in the open market. presents the risk. That doesn’t occur, That flattened portion of the line below however, with long options. $100 is the well-defined maximum loss working in your favor. No matter how If you buy a far the stock price falls below the strike call option, you at expiration, the most you can lose is CALL OPTIONS can only lose the amount you paid. PROVIDE A GREAT the amount HEDGE AGAINST paid. That’s The above graph crosses the horizontal DOWNSIDE LOSSES the absolute axis at $105, which is the expiration maximum. But breakeven for the call. Remember, because you the breakeven point is the strike plus have the right the price paid, or $100 + $5, which is to buy shares, you can also make an $105. If the stock is $105 at expiration, unlimited amount of profits if the stock you could sell the $100 call for the $5 rises – just like a stock owner. So the call intrinsic value, which is exactly the buyer has limited losses, but unlimited amount paid – you just broke even. gains. Rather than buying shares at Our second option advantage of $100, let’s assume you buy the $100 less risk becomes clearer when you call for $5. Your profit and loss diagram compare long shares of stock with a looks like the following chart: long call option:

Long Stock at $100 Long Stock/Long Call comparison

$20 $20 -$15 $10 $10 $0 75 80 85 90 95 100 105 110 115

$5 Loss Profit/

Profit/ Loss Profit/ -$10 $0 85 90 95 100 105 110 115 120 -$20 -$5 -$30 Stock Prices -$10 Stock Prices

The option advantage is easy to see. The long stock position (red) continues Notice the line bends at the $100 strike, to fall all the way down to a stock price which it doesn’t do for the stock. The of zero, as shown by the arrow, but the profit and loss curve for any option long call (blue) levels off at a $5 loss. always bends at the strike price (or You can also see the breakeven point strike prices for multi-legged strategies). for the call is pushed $5 further to the That because, if the stock price falls right compared to the stock. The $100 below the strike at expiration, there’s call breaks even at expiration at $105 no sense in exercising the call to buy whereas the stock breaks even at $100. Level Up Your Trading - CALL NOW: 866-443-8018 24 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

That additional $5 is the call’s extrinsic value. RISK MANAGMENT 101

In the above chart, notice that the red and blue lines cross at $95. That’s called the crossover point, and is the point AVOID EXTREME OUT- where the stock and call have identical COMES! DON’T INVEST losses. If the stock falls to $95, the stock buyer and call buyer lose $5. Notice WHERE YOU CAN MAKE that for all stock prices above $95, 100% IF IT MEANS the red line sits higher than the blue. That’s showing the long stock position LOSING 100% outperforms the long call by that $5 difference. However, look to the left of the crossover point, and you’ll see the ITM, ATM, OTM Call Comparison opposite occurs. The blue line always sits above the red line. So if the stock $25 price falls below $95, the call option $20 loses less than the long stock, and that’s $15 true all the way down to a stock price of $10 zero. In finance, whenever you sacrifice $5 $0 some gains in exchange for reducing 80 85 90 95 100 105 110 115 120 125

Profit/ Loss Profit/ $-5 risk, it’s called a hedge – a guard against $-10 ITM losses. Call options therefore provide a $-15 classic hedge because you’re giving up some of the possible gains in exchange Stock Prices ATM for greatly limiting the losses. OTM However, as discussed in the previous section, you can choose different So far, the arguments presented sure strikes. If you choose lower strike calls make is sound like a call option is just (ITM), the breakeven gets closer to the insured shares of stock. It’s a hard stock’s – but the option will cost more concept for new traders to understand. money. If you choose at-the-money How can you buy an option that costs (ATM) or out-of-the-money (OTM) far less money than the stock, but options, they’ll be cheaper, but the somehow say it’s a safer version? breakeven point is pushed further to the right. The option strike you choose Let’s buy 100 shares of stock, which is always a tradeoff in risk and reward has unlimited downside risk. To limit as shown in the following chart: that risk, we’ll buy the $100 put option, which gives us the rate to sell shares for the $100 strike. No matter how far the stock price falls, we can always sell the shares and receive $100. What does that look like?

Long Stock + Long $100 Put SHORTING SHARES OF STOCK

$20 When J.P. Morgan was asked what the stock market would do, he replied “It’ll $10 fluctuate.” If there’s one thing for sure, $5 stock prices will go up – and they’ll go

Profit/ Loss Profit/ $0 down. As traders, we can profit from 85 90 95 100 105 110 115 120 rising – or falling – prices. If you think -$5 prices will rise, you buy the shares, but Stock Prices -$10 if you think they’ll fall, you can short the shares.

It looks exactly like the call. The reason To short shares, you must have a the call option costs less is because we margin account. When you short don’t pay the strike price today. Instead, shares, you’re borrowing shares from we have the right to pay the strike price the broker and you sell them in the and receive the shares in the future if open market just as if you owned them. we choose to. It’s our right, or option, Technically speaking, the broker must to choose. locate the shares from another trader. If that trader wishes to sell his shares, the In options trading, a long stock position broker locates shares from yet another plus a put option is mathematically trader. It sounds complicated, but equal, or what’s called synthetically think of it like a savings account. If you equal, to a long call. A call option is deposit cash in your account, it doesn’t therefore nothing more than a long sit in a drawer with your name on it. stock position combined with a put, Instead, it gets loaned out. If you wish which means a long call is just insured to withdraw that money, the banker shares of stock. As with any insurance finds the cash from yet another person. policy, you never get back your initial That’s exactly what happens with short premium. In options trading, you’ll sales. You’re actually borrowing real never get back the extrinsic value – it shares from another trader. always becomes zero at expiration. However, the reason we pay for that You’ll receive the cash to your account insurance is that it limits the amount in the same way as if you owned the you can lose. The call makes the shares shares. The market doesn’t care if it’s less risky. an actual sale of shares, or if it’s a short sale. In the eyes of the market, a sale is Call options are therefore a great way a sale, so you get the cash. You won’t, to capitalize on bullish outlooks – where however, receive any dividends, as you think share prices will rise. Can we those go to the rightful owner of the get the same hedging benefits with puts shares. if we’re bearish?

If you short 100 shares, your account Let’s say you think shares of Apple position will show -100 shares, which will fall, so decide to short 100 shares means you’ve sold shares that weren’t at $144. By selling 100 shares, you’ll in your account, which is akin to receive $14,400, which is called the overdrawing a checking account. If your market value short. Just as with buying checking account says -$100, it means shares on margin, you must meet the you owe $100, just to get your account 50% Reg T deposit, or $7,200. Your back to zero. That’s exactly what’s total credit to your account is therefore happening with short selling. You have $14,400 from the sale of the stock + the obligation to deliver 100 shares $7,200 of your money, for a total credit back to the broker at some point in the of $21,600. The 50% deposit provides a future. There’s no time limit, provided cushion to the broker in case of adverse you can meet any potential margin stock price moves. If the stock price calls. To return the shares, you must falls, as you’re expecting, you can use buy them in the open market, which some of that credit to buy back the flattens your position. In other words, shares and keep the balance as a profit. minus 100 shares plus 100 shares That’s the ideal outcome. For example, equals no position. With shorting, if Apple falls to $140, you can spend you’re just working the “buy low, sell $14,000 to buy shares back, and you’re high” equation backwards. You begin left with $7,600 – exactly $400 more by selling at a high price but hopefully than you started with, which should buying them back later at a lower price. be the profit on 100 shares falling four For shorter sellers, the idea is “sell points. But if the stock price rises, you’ll high, buy low,” and the difference is the end up with losses, and eventually profit. When you short shares of stock, margin calls. Here’s the accounting for a your profit and loss diagram looks like short stock position: the following chart: Credit = $21,600 Short Stock + $100 Put - Market value short = $14,400 $30 = Equity $7,200

$20 Your equity percent is the equity/ $10 market value short, or $7,200/$14,400, $0 or 50%. Remember, whether you buy

Profit/ Loss Profit/ 80 85 90 95 100 105 110 115 120 $-10 or short shares on margin, you always Stock Prices begin at 50% equity. Now let’s say the $-20 stock price falls 10% to $129.60, your $-30 position looks like this:

The profit and loss chart clearly shows Credit = $21,600 that the risk of short shares is rising - Market value short = $12,900 prices. There’s no limit on how high = Equity $8,700 a stock’s price can rise, so the risk is theoretically unlimited. As long as the stock price climbs, you continue taking bigger losses. Level Up Your Trading - CALL NOW: 866-443-8018 27 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

Notice that falling stock prices increase the staircase, down the elevator.” Short your equity – just the opposite of buying shares can present some of the biggest, shares on margin. Here, the stock has most rewarding opportunities. If it just fallen 10%, but your equity increased wasn’t for the risk. from $7,200 to $8,700, or 20%. As with buying stock on margin, the 50% margin The risk side of shorting shares says requirement creates 2:1 leverage. Had it may be better to avoid any shorting the stock price risen 10% instead, your opportunity – until you understand how equity falls 20%. options make things less risky. Just as a call option protects you from the risk of While buying shares on margin certainly falling stock prices, put options protect poses big risks, shorting stocks creates you from the risk of rising stock prices. an even bigger risk. A stock’s price can only fall to zero, and no more damage When you buy a put option, you have can be done. But that’s not true when the right, not the obligation, to sell a stock price rises, as there’s no limit shares of stock at a fixed price, over a on how high prices can go. Each time given period of time. Because you’re prices rise, your equity falls, and you locking in your selling price, if prices can expect a margin call from your fall, the value of the put option rises. broker once your equity percent falls For instance, assume you think Apple below 30%. Let’s say the stock price is going to fall from its current price rises to $166.15: of $144. You might choose to buy the August $140 puts, which are currently Credit = $21,600 trading for $4. This gives you the right - Market value short = $16,615 to sell shares a fixed price of $140, no = Equity $4,985 matter how low the stock price may fall. At expiration, if the stock is $130, for Your equity percent has now fallen to example, the put option must be worth $4,985/$16,615, or 30%. If the stock the $10 intrinsic value. You paid $4 for price rises any further, you’ll get a the put and sold it for $10, and you margin call. Unlike a margined long profited from a falling stock price. stock position, this adverse rising stock price can theoretically go on forever. If you actually owned 100 shares of Short stock poses the biggest risk in all Apple, rather than selling the put for of trading. However, short positions are $10, you could exercise the put and important for traders because prices sell your shares for the $140 strike per rise – and fall. If you’re only looking for share. If shares are currently worth stock picks that are likely to rise, you’re $130, but you can sell them for $140, cutting out half the opportunities. When you’d make $10 – exactly the same as if it comes to making money, it doesn’t you sold the put in the open market. make a bit of difference if you buy at $100 and sell at $120, or if you short However, if the stock price remains sell at $120 and buy at $100. Further, above the $140 strike at expiration, stock prices often move slowly upward, the put option just expires worthless. but can come crashing down. It’s “up Nobody is going to buy that put from

you to have the right to sell at $140 That’s why the short stock position (red when they can just sell at the higher line) sits above the blue for all prices current market price. So the put protects to the left of the crossover point. For you from rising stock prices, and you’re all prices to the right, however, the put not going to end up in maintenance option limits the potential losses. calls and continued losses as with short Whether you wish to capitalize on bullish shares of stock. The put option won’t let or bearish market outlooks, buying that happen, and that’s why it’s less risky. options makes markets less risky.

Long $140 put @ $4 $20 THE RIGHT TO WALK AWAY $15 Another way to understand why options $10 provide a layer of insurance is that you have the right, not the obligation, to $5 buy the shares of stock. It’s the phrase Profit/ Loss Profit/ $0 “not the obligation” that makes the 120 125 130 135 140 145 150 155 difference. If prices move against you, -$5 Stock Prices you have the right to walk away from the deal. It provides a benefit that most investors fail to see. The limited risk of rising prices is easily seen when comparing the long $140 put Imagine that you’re at a horse race and to short shares at $144: could place your bets after the horses are halfway around the track. It seems Short Stock/ Long Put Comparison you’d have an unfair advantage, right? $30 $20 Well, that’s exactly what options allow you to do. By purchasing the call, you’re $10 locking in your potential future stock $0 125 130 135 140 145 150 155 160 165 price, but you’re not required to buy the

Profit/ Loss Profit/ $-10 shares. Instead, you can sit back and $-20 watch prices move up and down without Stock Prices fear – you’re not committed to buying $-30 the shares. The short stock position continues to take losses, as shown by the arrow, as Instead, you get to see how the race long as the stock rises – forever. The is unfolding – how the stock price is $140 put limits that risk in exchange moving – and then make your decision for giving up $4 worth of gains to the at expiration if you want to buy the downside. Long puts therefore provide shares. Even if the stock moves in your hedges against rising stock prices for favor, you’re never required to buy the short positions. The option reduces the shares. Instead, you can just sell the maximum gains by the amount of the call in the open market and capture the extrinsic value, or $4 in this example. intrinsic value that accrued during the option’s life. Level Up Your Trading - CALL NOW: 866-443-8018 29 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

It’s a big advantage, and that’s why you pay the extrinsic value. Being able to THE RIGHT TO WALK AWAY wait and see how things turn out before GIVES YOU AN ADVANTAGE buying the shares is one of the key benefits of having the right to walk away BY WAITING TO SEE WHAT from the deal. It reduces one of the HAPPENS TO FUTURE PRICES. biggest risks and fears among investors – the risk of the unknown future prices. Options make decisions less risky.

3 OPTION ADVANTAGE #3: BETTER RETURNS

The only reason for putting money it’s a 33% return. Losses work the same at risk in any investment is to end way. The less you invest, the bigger a up with more money than what you given loss looks in percentage terms. started with. To measure how well your investments are doing, most financial For comparisons, percent returns, or professionals use return on investment, ROIs, or usually given on an annualized or ROI. basis, which means to assume the return could be continued over the To calculate the ROI, there are two easy course of a year. The reason for doing methods. First, take the amount of this is simple. If your bank pays 5% per profit (or loss) and divide it by the initial year and another bank pays you 5% for investment, called the principal, and six months, you can’t say they’re paying express it as a percentage. For example, the same 5% rate. To annualize, you assume you bought shares of stock count how many “periods” there are for $100 and sold them for $120. You in question. made a $20 profit, which is the amount “returned” to you from your investment. Here, the first bank pays over one If you divide that by the $100 principal, year, so it’s already annualized. The you get $20/$100, or 20%, which is annualization factor is “1” so the rate your ROI. is 5% * 1, or 5%. The second bank pays every six months, and since there are The second method is a touch easier. two “six-month” periods in a year, it’s Take the selling price and divide it by annualization factor is two. The second the principal. Then subtract one, and bank therefore is paying 5% * 2, or make it a percentage. Using the above 10% per year. Now that both banks example, take $120/$100, which equals are annualized, you can make fair 1.20. After subtracting one, you get comparisons. The second bank is paying 0.20, which is a 20% ROI. twice the rate of the first bank, even though both rates are being quoted as Losses work the same way. If, instead, 5%. It’s the time periods that matter. you sold for $90, you lost $10, which is return of -$10/$100, or -10%. Using If the second bank had, instead, paid the second method, $90/$100 = 0.90. 5% every quarter, there are four Subtracting one gives you -0.10, “three-month” periods in a year, so or -10%. the annualized return is 5% * 4, or 20%. Be careful about annualizing It should make intuitive sense that for any investment under 60 days. As you any given profit (or loss), the smaller the get closer to zero, you get incredible initial investment, the bigger the ROI. annualization factors, so results can If you paid $100 and sell for $120, it’s a appear to be more impressive than 20% return. However, had you paid $95, they really are. If you buy an option it’s a 26% return, and if you paid $90, Level Up Your Trading - CALL NOW: 866-443-8018 31 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

for one dollar, and sell it for $1.10 time of purchase. As shown previously, in one minute, it’s a simple return of the additional dollar is the extrinsic 10%, but annualized it works out to be value providing downside protection in over 5,256,000%. Hardly meaningful. case you decide to walk away from the Still, it’s important to understand, as deal. In the meantime, you control the many trading services flip traders in stock for all price movements as if you and out of positions every few minutes had fully paid for the shares, so options for nickels and dimes – plus lots of are a mathematical form of borrowing commissions – and annualize the money. returns to make it sound to the rest of the world like they’re doing For investors, there are two basic amazing things. forms of leverage:

1. Buy a bigger position for a given OPTIONS LEVERAGE amount of money: For example, rather than buying 100 shares of Options provide a natural form of Apple for $144, take the $14,400 leverage because they allow you to cash and buy seven calls at $20, capture dollar-for-dollar moves in the which controls 700 shares. This is stock’s price at expiration – but for a lot the dangerous form of leverage that less money. Financial leverage is usually we never recommend. It’s a bigger accomplished by borrowing money. position (700 shares compared to With call options, you’re mathematically 100) but for the same $14,400. borrowing money because you’re not 2. Buy the same-sized position for paying the strike price today. Instead, less money. For example, control you have the right to pay that in the 100 shares for $2,000 rather than future and buy the shares. In some $14,400. This is the advantageous ways, buying calls is like a lay-a-way use of mathematical leverage. plan. You put a small amount of money Plus, you’ll have $12,400 sitting in down, but “own” all the items. You own cash to take advantage of other them; you just haven’t fully paid for opportunities, or perhaps buy them yet. put options as another layer of insurance. In fact, you might even Go back to the example where Apple decide to go 2:1 and control 200 was trading for $144 and the $125 shares for $4,000. You still have call was $20. Think about the call like far less money at risk, and you’re a lay-a-way plan. You put $20 down – controlling more shares. At Market but control 100 shares as if you had Rebellion, we consider this an fully paid for them. If you choose, you acceptable use of leverage, provided can exercise the call and pay the $125 you don’t exceed the 2:1 ratio. strike at expiration to actually own the shares. You’ll pay the $125 strike but you already paid $20 for the call, which means your total cost is $145 – even though the shares were only $144 at the

SHORT SHARES OF STOCK You could buy a higher strike put with more intrinsic value – and less extrinsic Options leverage works in both value. The Apple August $170 put was directions – up and down. If you short trading for $27.10. With the stock at shares of stock, you can make a lot of $144, it has $26 of intrinsic value and money, but you’ll also have a lot of risk. $1.10 of extrinsic. Yes, the options The money you do post for margin costs more money, but it’s going to do ends up working far harder than it does a much better job of mimicking short when you buy options. shares of stock since there’s so little extrinsic value. Remember, it’s the Let’s go back the example of shorting extrinsic value that always pushes the 100 shares of Apple at $144. If the stock breakeven point further away from the falls $15, or about 10%, to $129. That’ll current stock price. equate to a 20% return on your money since you must short shares on margin, If you bought this put and Apple falls and you’ll have 2:1 leverage. However, to $129, the put is worth the $41 worth if you bought the $140 put for $4, at of intrinsic value at expiration. Because expiration, it’s worth $11 of intrinsic you paid $27.10, your profit is $13.90, value. By owning the put, you have and your ROI is $13.90/$27.10, or 51%. the right to sell shares for $140 – even It’s not as impressive as 75% achieved though they’re trading for $129, so the with the $140 put, but it also didn’t put is worth the $11 difference. You require the stock to make as big of a made a $7 profit on a $4 investment, or move. There was a larger probability for 75% return. Why didn’t you make $15 reward and therefore lower returns. like the short stock seller? The short stock trader made $15 profit This put was $4 out of the money when and as the $170 put buyer, you’re only you bought it. You needed the stock missing that number by $1.10 – exactly to fall $4 just to begin to get in on the the amount of extrinsic value. The $170 action. Second, you paid $4 of extrinsic put allows you to enter profit territory value, which goes to zero at expiration. quicker, so it’s acting more like a true So that’s $8 you gave up. Because the short stock position, but it also exposes stock fell $15 and you gave up $8, you’re you to larger losses if you’re wrong and left with the $7 difference. If you’re the stock price rises. thinking that’s a lot of potential profit to give up, remember that options give you options. The OTM put was cheaper, but it requires a bigger move from the stock since the breakeven point is pushed a lot lower. Remember, this put’s breakeven point is $140 strike - $4 price, or $136. You needed the stock to fall to $136 just to break even. How could you increase the breakeven point?

4 OPTION ADVANTAGE #4: MORE WAYS TO PROFIT

Stock traders get two choices: up or much to do for stock buyers. Your long down. If you think the stock’s price is shares are losing money, or if you’ve moving higher, buy the shares. If you gone completely to cash, earning feel it’s moving lower, short the shares. nothing. However, because of the risk of shorting shares, most stock investors only Put options, however, give buyers focus on rising stock prices. They buy a perfect hedge against rising stock and hold. prices. They allow you to participate in bearish outlooks without the fear As options traders, however, you can of being wrong. Once you understand easily make money on rising prices, puts, the universe of opportunities falling prices – or even stagnate prices. opens, and you have more ways to That’s right. You can make money if profit. Recall that calls and puts are prices go nowhere. Options simply give like driving in the northbound and you more ways to profit compared to southbound lanes. The rules are shares of stock. Let’s take a closer look identical; it’s only the direction that at the three key ways you can make differs. All the great risk-reducing money from options that you can’t do features of calls are present in puts. with shares of stock: It just depends on whether you wish to be bullish or bearish. 1) Ease of participating in bear markets 2) Profiting from sideways prices If you believe a stock’s price is going to 3) Profiting from volatility changes fall, you can buy puts just as easily as you can buy calls. Let’s say you think In short, options give you choices that Microsoft (MSFT) is going to fall from you wouldn’t have by using shares of its current price of $68. In the stock stock. market world, the only choice you have is to short shares, which shown, is far too risky for most people’s taste. EASE OF PARTICIPATING Instead, you could buy puts. The IN BEAR MARKETS expiration date you choose is a matter of choice, but you want to be sure you At any time, about half the stocks in the buy enough time so the stock can react market are rising and half are falling. in the way you’re thinking. Don’t buy Most stock investors, however, focus super short-term options just because on buying shares, partly because stocks they’re cheaper and hope that the have a long-term upward price bias, stock instantly falls. Let’s say you buy but mostly because of the risk of the August $65 puts with 111 days to shorting shares. expiration, which are trading for $1.50, or $150 total. Just like call buying, once When markets are stagnant, or even you buy the put, that’s the most you unraveling like in 2007, there’s not can lose. It’s an automatic hedge in Level Up Your Trading - CALL NOW: 866-443-8018 34 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

case you’re wrong. This put will expire the 75% return is less than the 100% worthless if Microsoft closes at the $65 return realized on the $65 put. That’s strike or higher at expiration. You don’t again the risk-reward tradeoff. By get that luxury with short shares. creating a higher probability for profit with the $75 put, you’ll pay more for If Microsoft falls, as you expect, the put it but receive a smaller return. So not begins to gain value. If the stock falls to only do options give you more ways to $62 at expiration, you can sell the $65 profit, they also allow you to choose put for its $3 intrinsic value. You paid different risk-reward profiles, you don’t $1.50 and sold for $3, and you doubled get that with short shares of stock. The your money even though the stock only chart below shows the profit and loss fell less than 5%. By shorting shares, diagram for the $65 and $75 puts: you would have made 10% since you get 2:1 leverage with short shares. Short shares expose you to far more risk and MSFT $65/$75 Put Comparison provide smaller returns. $35 The $65 put is out of the money, so you $30 do need the stock to move to produce $25 profits. For example, if the stock falls from $68 to $65, your put expire $20 worthless – even though you were right $10 that the stock would fall. If you were $65 more confident in your prediction, you Loss Profit/ $5 put may choose the $65 strike. But if you $0 wanted the put to behave more like 35 40 45 50 55 606570 75 80 95 1009085 105 short shares, you might choose a -$5 higher strike. $-10 Stock Prices The $75 put is trading for $7.50. It’s more expensive, but it’s going to act more like short shares – but still without You can see from the chart that if the unlimited risk. The most you can the stock falls, the $75 put (red line) lose is $7.50, but you’ll reach your performs better because it sits above breakeven point sooner. The $65 put’s the blue line ($65 put) for all prices breakeven is $65 - $1.50, or $63.50. below the crossover point. But if you’re The $75 put’s breakeven is $75 - $7.50, wrong and the stock rises, the blue line or $67.50, so you can see the $65 put sits above the red. That is, the cheaper needs the stock to fall further before $65 put affords more protection. No profits are realized. It’s riskier than the matter which strike you choose, you’ll $75 put. get a little different risk-reward profile. There’s no way to get these finely-tuned If Microsoft falls to $62 at expiration, choices by shorting shares – it’s all or you could sell the put for the $13 nothing. intrinsic value, or a 73% return. Notice

PROFITING FROM SIDEWAYS PRICES line; that is, you don’t lose a proportional OPTIONS amount of value Whether you’re bullish or bearish, stock PROVIDE A investors need prices to move. For compared to the options traders, however, that’s not time that has eroded. MATHEMATICAL true. The reason is that options have an Instead, options decay LEVERAGE BY extrinsic value, which absolutely must according to a square- ALLOWING YOU root principle: If half fall to zero at expiration. Because of TO FLOAT THE this, a portion of the option’s price will the time remains, the decay with each passing day, which is option’s price will be EXERCISE PRICE called time decay, and you’ll sometimes √0.5, or about 71% of hear options called wasting assets. its starting value (or Just because they decay doesn’t mean lose 29%). If ¼ of the time remains, then they’re bad. Just about everything √0.25 is 0.5, so the option will retain half you buy is a wasting asset. Fruits and its initial value (and lose half). vegetables, cars, computers, cell phones – all eventually become worthless, yet The point to know for now is that option we buy them. Why? prices do not decay in a straight line. It’s not a linear rate of decay. Instead, they Because they’re productive assets in the begin to decay slowly, and accelerate meantime and provide value in other as expiration nears. The following ways. There’s a cost to using them, and chart shows time decay for a six-month that’s depreciation. It’s the same idea option trading for $2.50: for options. They provide tremendous benefits, and there’s a cost, which is the Time Decay extrinsic value. $3.00 $2.50 For example, the Microsoft October $2.00 $70 call with 180 days to expiration $1.50 is trading for $2.50. With the stock at $1.05 $68, this call has no intrinsic value, $1.00 Option Price and the entire $2.50 is extrinsic value. $.05 Remember, only the extrinsic value $0 decays, so this option’s price will slowly 0 20 40 60 80 100 160120180140 work its way toward zero, provided Days Passed Microsoft remains below the $70 strike.

You wouldn’t be alone if you feel that The blue curve shows the true decay the option should lose half of its value in the option’s price. Notice it initially after half the time has passed. It’s drops slowly, but accelerates once intuitive, but it’s wrong. Option prices you get within the final 30 days. The are based on the underlying stock’s red dotted line shows how time decay volatility, which is a little outside of the would look if it was linear. The concept scope of this book. Just understand that to understand is that options decay option prices do not decay in a straight slowly at first – but rapidly near the end. Because options decay over time, and Level Up Your Trading - CALL NOW: 866-443-8018 36 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

because they decay at different rates, it’s just the obligation to sell should the they present completely different ways long call decide to exercise. However, to profit rather than just predicting this doesn’t pose a risk since you own whether stock prices will rise or fall. the shares.

For instance, let’s say you own 100 But let’s say the stock sits still as you shares of Microsoft but feel it’s going predicted. As time passes, the option’s to sit flat over the next month, value will decline, which is good for perhaps while waiting for the next you as the seller. The seller benefits earning’s report. when the option’s price fall. The buyer benefits when the price rises. The two Microsoft currently has an ATM $68 traders are on the opposite side of the call expiring in two weeks trading for transaction, so they have the opposite 75 cents. If you believe the stock will outlooks. remain quiet, you could write, or sell the $68 call. You’re the writer and another At expiration, if the stock is at the $68 trader is the buyer. It’s not a naked call strike or lower, the call option expires because you own the shares. In fact, worthless, and you collect the entire 75 owning shares of stock and selling a cents. It may not sound like much, but call against them is a well-known remember this is a two-week option. If strategy called the Covered Call. It’s you do sell another call over the next also called a Buy-Write strategy since two weeks, you’ve collected $1.50 for you’re buying the shares and selling or the month, which is a 2.2% return, or “writing” the call. 26% annualized. Not bad for the stock price going nowhere. Once you sell the call, you’ll receive 75 cents per contract, or $75 total. What happens if the stock price rises If you own 400 shares, you’d receive above the $68 strike? You have two $300 cash, and so on. You’re also not choices: First, you can do nothing and required to sell calls against your entire will likely get assigned and must sell the stock position. If you own 400 shares, shares. The worst that happens in that you could sell one to three contracts case is that you lose the shares. Second, and leave 100 shares free and clear you could choose to buy the call back should the price rise. to escape your potential obligation to sell your shares. Let’s assume the By selling the call, the cash also stock rises to $70 at expiration and with provides a small downside hedge. If the worth the $2 intrinsic value. If you buy stock is currently worth $68, you can back the call for $2, it leaves you with afford to have the price fall by 75 cents a $1.25 overall loss since you initially to $67.25 and just break even. That’s received 75 cents. It may seem you’ve the benefit. In exchange for the cash, got a loss. However, by buying back the you have the potential obligation to sell call, you’re no longer obligated to sell your shares – only if the long call owner your shares for the $68 strike. Instead, decides to exercise. Selling calls does you could sell them for the current not create a guaranteed sale. Instead, $70 market price. By buying back the

$68 call, you’ve increased your stock’s even if options weren’t available, then value by $2. So overall, you’re ahead the downside risk is being assumed by 75 cents – exactly the amount of the prior to the call sale, and the strategy extrinsic value. No matter how high the didn’t introduce any new risk. stock’s price may climb, the math works out the same. You’ll always be ahead Selling calls against shares makes by the option’s extrinsic value. The statistical sense. In most cases, stock point is that just because the stock rises prices remain fairly quiet, at least in the above the strike doesn’t mean you short run. Your best guess as to a future must let your shares go. You can always stock price is today’s price. Most of the buy back the short call at any time time, therefore, you should expect your for any reason. What’s the risk of the long shares to remain quiet. Options Covered Call? can help.

The risk is the downside – falling stock prices. You own the shares, and even though you received some cash which lowers your breakeven price, you’re still holding most of the downside risk. If you’re comfortable holding the shares and would be holding them anyway

STOCK PRICES & BELL CURVES

If you look at daily stock price returns, they tend to follow bell-shaped curve. Stock prices move higher, they move lower, but overall, they’ll tend to stay near the center of the bell-shaped curve, especially in the short run. In the bell curve below, the center represents Microsoft’s current $68 market price. The light red plus dark red shaded areas show a hypothetical probability for the stock to exceed the current $68 by expiration in two weeks:

0.45

0.4 0.35 0.3

0.25

0.2 Probability 0.15 0.1 0.05 0 65 66 67 68 69 70 71 Stock Prices

Because it’s an ATM option, there’s a As a call seller, you can sell calls month 50% chance for the stock’s price to rise after month, and because short-term above the $68 strike. By selling that options decay quickly, the calls will also strike, you’ll receive the most extrinsic lose value quickly, which is great for the value. However, if you wanted to seller. At any time, you can certainly buy decrease the chances for the stock to the calls back. rise above the strike, you could choose to sell a higher strike, say the $69 strike. You’ll get less money, but have a better chance of the stock remaining below the strike as shown by the dark red area.

HOW VIABLE IS THIS STRATEGY?

The Chicago Board Options Exchange (CBOE) created the Buy-Write Index (BXM), which is a hypothetical option selling strategy against the S&P 500. One-month calls are written that are slightly OTM each month and settled in cash. Because writing calls outperforms when prices stay quiet, the BXM tends to outperform the S&P 500 when the market is down, but will usually underperforms when the market rallies. The chart below shows compares the S&P 500 to the BXM (solid red line):

SOURCE: OptionsHouse. Market Rebellion is not endorsed by or affiliated with OptionsHouse.

Writing calls against shares of stock is a popular and powerful way for investors to generate income. It’s an impossibility without options. PROFITING FROM VOLATILITY CHANGES

Anyone who’s invested certainly knows that don’t move much are low-volatility that stock prices can make radical stocks. Volatility has nothing to do with changes – higher and lower. Some direction. A volatile stock just means the stock exhibit fairly small price changes stock’s price could make a large move, over time, while others can make large whether up or down. When you hear changes. Stocks like General Electric and the word volatility, don’t associate a AT&T don’t move much during the day, directional aspect to it. It doesn’t mean while stocks like Google and Priceline the stock is destined to rise or that it’s can make large moves, even during about to plummet. Instead, it means the day. Stocks that exhibit large price either is possible. swings – up or down – are volatile. Ones

It’s the concept of volatility the provides the future than they are now, you’ll see an option’s value. Volatility is the reason traders bid up the extrinsic value. That traders pay extrinsic value. Think about Priceline option may suddenly jump a $100 stock that doesn’t move much. from $48 to $50 – even if the stock’s How much would you pay for a one- price hasn’t moved. Instead, the option’s month $100 call? Probably not much price is changing based on the market’s since there’s not much of a chance that perception of future volatility. the option will gain a lot of intrinsic value. However, if a stock can make To understand the concepts better, really large moves, that same $100 consider an extreme example. Let’s call is now worth a lot of money. If say a stock is $50 and the OTM $55 call traders think there’s a good chance is trading for one dollar. A few days that stock could be trading for $130, for later, the stock price is still $50, so instance, they’ll be willing to pay a lot theoretically the option should have lost for the option. a little value. However, a news article breaks that says this stock is a potential There’s a mathematical formula for takeover target for $70. Would you measuring volatility, and it’s always want to buy the $55 call? Sure – and so reported as a percent. The larger the would everybody else. The market ends number, the more volatility the stock up with a lot of buying pressure, and price exhibits – and the larger the few people wishing to sell. The result is option prices you’ll see. For instance, that the option’s price may rise from $1 a one-month ATM call on AT&T (T) is to $5, even though the stock’s price may trading for 42 cents. For that same not have reacted. Instead, it’s just the expiration, a Priceline (PCLN) ATM market’s way of adjusting to the new call is $48 – over 100 times the cost. volatility level. The reason is that Priceline is more volatile and has the ability to pump When you involve options into your a lot of intrinsic value into any strike, portfolio, you can now trade volatility. and traders are willing to pay for those You don’t need the stock’s price to potential rewards. move, but instead, just need to see the market increase its future volatility When learning options, don’t ever expectations. For instance, most higher- think that the 42-cent option, for volatility stocks will have their volatilities example, is a better deal than the $48 increase just prior to an earnings one. They’re both priced according report. As that date approaches, the risks and potential rewards. It’s speculators jump in and begin bidding the concept of volatility that drives an up option prices, even though the option’s extrinsic value. However, as underlying stock may not have moved. market conditions change, traders will Instead, it’s the market bidding up the adjust their valuations on the extrinsic volatility. A common strategy is to buy value. In the options trading world, an option, and hold it in anticipation of we say that traders are adjusting their rising volatility. When the price rises, volatility valuations. If people believe, you can sell the option for a profit, even for whatever reason, that future price though the stock may not have moved. changes – volatility – will be larger in Level Up Your Trading - CALL NOW: 866-443-8018 41 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

SOURCE: OptionsHouse. Market Rebellion is not endorsed by or affiliated with OptionsHouse. For illustration purposes only. Not a trade recommendation.

The OptionsHouse platform plots If you look throughout the above historical volatilities compared to what’s chart, you’ll see several times when called the implied volatility, which is the orange line made a similar move. the price traders are willing to pay for Those are always earnings reports, or the option. For instance, Priceline’s the anticipation of some pending news. earnings are coming up in the next 10 Notice too, however, that the orange days. Notice how the right side of the line also subsides, and returns back chart (red box) shows the orange line toward the center of the graph. That’s (implied volatility) is significantly above called mean reversion, which simply the blue line (historical volatility). This means that volatility tends to follow always happens for stocks that have a long-term average, or mean. When the potential for surprise earnings. it’s above that average, it tends to fall Speculators don’t want to own the risky toward the average. When it’s below shares. Instead, they compete for the the average, it tends to rise toward options by bidding up the extrinsic the average. That is, volatility tends to value, and that’s what causing the revert toward its mean. You can see orange and blue lines to separate this sideways motion in the chart. That’s (red box): true for any stock or index. You’ll see volatility just trade sideways over time; it’s one of the few constants in the financial markets. Whether volatility is high or low, it creates wonderful opportunities unavailable to stock traders.

5 OPTION ADVANTAGE #5: BARRIERS TO SHORTING STOCKS

In the second advantage, “Less Risk,” Another related problem exists when we showed the mechanics of shorting stocks have a limited float, or number shares of stock and the risks involved. of shares available to the public. As Now it’s time to unveil another related discussed before, when you short option advantage: Barriers to shorting shares, the broker must physically stocks. locate an equal number of shares from a margin account. As part of the margin Despite the risks, some traders are agreement, you’re allowing the broker willing to short shares. However, for to have access to your shares. In some those who feel they don’t need to cases, however, investors may find their understand puts because they’ll just stock is being heavily shorted, and they short the shares, there may be times message everyone through the Internet when that idea won’t work. to move shares to the “cash” account or Type 1 account. A cash account can For instance, there are certain types exist within a margin account. So even of accounts where you can’t have though you may have a margin account, margin, no matter how much money you can have the broker move shares to you have, such as IRAs or other tax- the “cash” side of the account. Doing so advantaged accounts. However, most means that the broker cannot use those of these accounts do allow options shares for shorting. trading. If you’re wondering how you can trade options without a margin However, when investors are taking agreement, it’s called IRA margining, these drastic measures, it’s usually for which is different from a regular stock good reason. But if your broker can’t account. So you can buy puts in an IRA, locate shares, you can’t short them – but you can’t short shares of stock. The but you can always buy puts. main reason for this is that there’s no theoretical limit on how high a stock’s price can rise. No matter how much VOLATILITY RISING money you may have, you’re restricted to how much you can deposit into an There can be times when volatility gets IRA in any year. If you short shares and high, and markets seem on the edge the stock gaps up higher, you may have of coming apart. When that happens, a negative balance, and there’s nothing some brokers won’t allow you to that can be done. The broker usually short shares, even though it seems charges it off to an error account. like the perfect time to do so. Another possibility is that the broker may make When you buy puts, however, you pay the Reg T requirement far greater than for 100% of the option’s price up front, 50%, such as 70% or 80%. Remember, so there’s no risk of not being able to brokerage firms can’t relax rules, but meet any margin calls. That’s why you they can make any rule stricter, and can buy puts, but can’t short stocks. Level Up Your Trading - CALL NOW: 866-443-8018 43 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

they can change the rules at any time. pocket and end up taking a loss. You Even if you’re already short the shares sold it for 70 cents, but bought it back and the broker changes the rules, for $1.50, for an 80-cent loss. That’s the firm can demand more margin exactly how shorting shares of stock money, even though you’re not in a works. maintenance call. It’s another risk of being short shares. The idea to understand is simple: When you borrow shares, your obligation is to return an equal number of shares to INVESTOR PSYCHOLOGY the broker. If you sell them today at one price, but buy them back later for less Even seasoned investors can find money in the future, you’ll have a profit the concepts of shorting stocks a bit from the transactions. In the stock strange. How do you sell something you market, if you think prices are going don’t own? And how does that allow to fall, you can short shares just as you to make money? What’s margin and easily as you can buy them. Borrowing why is it so risky? And on and on go the shares from the broker sounds like a questions. Most of the time, investors complicated process, but it’s all part of stick with the bullish side. It’s easier to the margin agreement. It takes a matter understand and what they’ve always of seconds, just as it takes a second to understood. borrow money on a credit card. It’s built into the system, and every broker is set Shorting stock isn’t so hard to up to allow short selling. understand. At Market Rebellion, we make sure our investors and traders Assuming you have a margin account understand all aspects of the market, so and can meet the initial Reg T amount, let’s make sure it’s not so mysterious. just sell shares you don’t own. If you don’t own any shares of IBM, but press First, think about what it means to the “sell” button, you’ll be short the borrow something. You have the shares. If the stock is trading for $100, obligation to return it, or to return an you’ll receive $10,000 cash just as if you equal size and quality. For instance, if sold shares you did own. Because you you borrow a cup of sugar from your didn’t have the shares in your account, neighbor, your obligation is to return your positions screen will show IBM one cup – not to return an equal dollar -100 shares. That means you’re “short” amount. Let’s say you take that sugar shares and must return 100 shares in into the street and sell it for one dollar. the future. You take that dollar and walk to the store, where you can buy a cup of sugar Just as with the sugar, you’re not for 70 cents. Take the dollar from your required to return an equal dollar pocket, buy the sugar, and return it to amount. You’re not required to return your neighbor. At the end, you have an $10,000 worth of stock. If that was the extra 30 cents in your pocket. That’s rule, shorting wouldn’t work because the reward from the transactions. Of you’d always have to pay the same course, if sugar had been $1.50 at the price at which you sold. Instead, you’re store, you’d have to dig into another Level Up Your Trading - CALL NOW: 866-443-8018 44 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

required to return 100 shares. If share market can offer. Put options change prices fall as you expect, you can buy that. There’s no borrowing, no Reg T, the shares back for less money, and and no margin calls. Just buy the puts, you’ll have a profit. The broker realizes and they’ll become more valuable as the you had -100 shares, and the purchase underlying stock falls. If you’re wrong, of +100 flattens your position. You sold the most you can lose is the amount high, and bought low. On the other paid. It’s an automatic hedge in case hand, if prices rise, you’ll pay more for you’re wrong and the stock price rises. the shares and end up with a loss. While it’s never fun to lose 100% of your investment, remember that the put will For investors not familiar with shorting, cost a small fraction of what it would it does seem like a strange idea, and cost to short the shares. And if you’re that’s why most people never entertain wrong there, there’s no limit on how the idea. Unlike professional investors, much you can lose. The put options they’re also missing out on some of open the door for new opportunities the most profitable opportunities the you never considered.

OPTION ADVANTAGE #6: ABILITY TO 6 GENERATE INCOME

In Option Advantage #4, we showed shares every month. At expiration, that options provide multiple ways all the extrinsic value evaporates, to profit – not just from stock prices and you’re ahead by that amount. moving up or down. One of the keys in that section was the ability to profit Recently, the exchanges created “mini” from an option’s price decaying. People option contracts that control only often think options are bad because 10 shares of stock rather than the their prices decay, but that’s not standard 100. So if you own fewer than thinking like a financial expert. If that’s 100 shares, say 70 shares, you can sell really the concern, take the opposite up to seven contracts against those side of the trade – be the seller. What’s shares. Mini contracts only exist on a good for the buyer is bad for the seller handful of stocks and indexes now, but and vice versa. If time decay harms it’s a sign that all investors are seeking a long option, it’s a benefit for a short income – even those who own fewer option. than 100 shares. Income-producing strategies are one of the key benefits Time decay sets up another category of for stock investors. However, they also benefits: Options can generate income. apply to option investors. Regardless The Covered Call is probably the most of how they’re applied, options traders popular way for stock investors to refer to these strategies as premium generate income. If you own shares of collection strategies. stock, you can sell options against those

SPREAD STRATEGIES

One of the easiest ways to see how a The two-week $162.50 strike is trading premium collection strategy applies to for 75 cents. If you sell this strike, you options is by using spread strategies. have the obligation to sell 100 shares Spreads are a generic brand of financial for $162.50. Even though you don’t own strategies that involve the combination the actual shares, you do own the $150 of buying one asset and selling another. call, so you could always buy the shares Spreads can be used with many types of for less money than the price you’re assets, not just options. required to sell them. Your return is 0.75/$11, or 6.8% for two weeks. With Let’s go back to an earlier example 85 days to expiration on your long where IBM was trading for just over position, you could sell options like up $160, and this time you buy the IBM July to six times. $150 call for $11. This option only has about 80 cents of extrinsic value and The Diagonal Spread makes the strategy has 85 days to expiration, so it’s only one with limited risk and limited going to decay a small amount between rewards: now and expiration. In the meantime, why not generate some income?

Diagonal Spread $20

$15

$10

$5 Probability $0 71 77 83 89 95 101 107 113 119

-$5

-$10 Stock Prices -$15

If you owned five of the $150 calls, the options quotes, the prices appear you’d receive $375 cash every two on the “diagonal” since you’re dealing weeks – it’s an income-producing with different expiration months and strategy. This is a strategy called a strikes. No matter what you call it, Diagonal Spread because if you look at it’s ultimately an income-producing strategy. Level Up Your Trading - CALL NOW: 866-443-8018 46 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

VERTICAL SPREADS

A similar strategy is the Vertical Spread. It’s like the Diagonal Spread, except that both strikes share the same expiration. It’s called a “vertical” spread because the quotes appear in the vertical column of the quotes.

While long options greatly limit downside risk, Vertical Spreads do an even better job. For instance, Priceline (PCLN) options are very costly because of the stock’s price along with the volatility. Look at the June $1895 calls with 30 days to expiration below trading for $33.95:

SOURCE: OptionsHouse. Market Rebellion is not between the two prices, which is why endorsed by or affiliated with OptionsHouse. For illustration purposes only. Not a trade most platforms will calculate this recommendation.. average price for you. You may wonder why we’re not referencing the $35.60 asking price like With the stock price just below $1,895, we have been with most examples. this call’s price is pure extrinsic value. Whenever you’re dealing with high- That means you’re paying $3,395 per volatility stocks, the bid-ask spreads contract just for the right to buy the (difference between the bid and ask shares, and if that stock’s price isn’t prices) can get quite large, so it’s a good above $1895 at expiration, you’ll lose idea to trade at the “mark” or midpoint the entire purchase price. The call still

offers protection since it limits your both options will be in the money at losses to $3,395, which is much less expiration. With 30 days remaining than owning 100 shares of stock for until expiration, you may need to see over $189,000. Still, for many investors, Priceline rise another 50 points or more $33.95 is a lot to lay out for one option before the market starts moving that position. You could choose to let the spread’s value toward five dollars. opportunity pass you by, but you can also use the option advantage and Second, Priceline can rise only a little find a solution. You can do that by and trade for just above the short generating income. strike of $1,900 – but with only seconds remaining until expiration. In this case, You can sell a higher strike, say the both options aren’t very deep in the $1900 call, with the same expiration. money, but there’s no time left on the By selling this strike, you can expect to clock, so the market knows the spread receive the $31.30 bid (red box) and must be worth five dollars. However, greatly reduce the amount you must prior to expiration, the market will pay. Your net payment is therefore discount that $5 potential price because $33.95 - $31.30, or $2.65, which is much of the uncertainty, and right now, the cheaper than $33.95. market is valuing the spread at $2.65.

This is called the 1895/1900 Vertical So if you buy this Vertical Spread for Spread. By selling the $1900 call, $2.65 and the most it can be worth is you did collect $31.30, which greatly $5, your maximum profit is the $2.35 reduces your cost, but it also creates a difference, for an 88% return. To make combination of rights and obligations: this return, the stock’s price must be You have the right to buy shares anywhere above $1,900 at expiration. for $1,895 and the obligation to sell If the stock falls below $1,895, you’ll them for $1,900, so the most you lose your $2.65 investment. By selling could ever make is the $5 difference another call and generating income, in strikes. Therefore, the most this you’ve reduced the total cost, and in Vertical Spread can ever be worth is return, you’ve reduced the amount five dollars. However, just because you can make. Options allow you to that’s the maximum it could ever be partition a stock’s price into much worth doesn’t mean the market will smaller increments, so you can easily necessarily price near that level. It all alter the risks and rewards. Contrast depends on how confident investors this with just buying 100 shares for are that both options will expire in the over $189,000 and not knowing what money, which is the only time we can your gains or losses will be. You’ve got definitely say it’s worth five dollars. the potential for unlimited gains, but you can also lose a ton. Most investors The market will price this spread at would just avoid the opportunity, but $5 under two basic scenarios: First, options give you advantages. if there’s a lot of time remaining until expiration, Priceline must rise much higher so that the market feels

The Diagonal Spread and Vertical Spreads are directional strategies, as you need the stock to move in a particular direction to reach maximum gains. Like all options strategies, you can make any bullish or bearish depending on which options are used. The two charts below show a bullish and bearish Vertical Spread:

Bull Vertical Spread NEUTRAL SPREADS

$3 Because options are so versatile, you can make premium collection strategies $2 neutral. With neutral strategies, you’ll make your maximum gain if the stock $1 stays still, or sits in neutral. One such strategy is called a Time Spread, also $0 Profit/ Loss Profit/ 1885 1890 1895 1900 1905 1910 called a Calendar Spread. With this strategy, you’ll use different expirations -$1 like you would with a Diagonal Spread; however, you’ll use the same strikes. -$2 For instance, if you buy the March $100 -$3 Stock Prices call and sell the January $100 call. You have the right to buy stock for $100, but you also have the obligation to sell for $100, so it sounds like you can’t make any money. Remember, however, that you’re dealing with different strikes Bear Vertical Spread and different expiration decay at $3 different rates.

$2 Longer-dated options decay slower than shorter-dated ones, so as time passes, $1 the difference between the prices increases, provided the stock price $0 Profit/ Loss Profit/ 1885 1890 1895 1900 1905 1910 remains fairly still. For instance, assume that a 120-day $100 call costs $2 while -$1 a 30-day $100 call costs $1. If you buy the $2 call and sell the $1 call, your net -$2 payment is the $1 difference. That’s the -$3 Stock Prices most you could lose. What’s the most you can make?

In 30 days, if the stock remains at $100 at expiration, the 30-day call expires worthless and loses 100% of its value. The 120-day call, however, is now a 90-day call and has only lost 14% of its value. It’s trading for $1.73. You could sell your long call for $1.73 and would owe nothing to close the short call, so your net proceeds are $1.73. You paid $1 and sold for $1.73 – and all because the stock’s price went nowhere:

Time Spread

$1 Probability $0 80 85 90 95 100 105 110 115 120 -$1

-$2 Stock Prices -$3

The number of possible premium collection strategies are numerous, and our goal isn’t to cover them in detail. Instead, it’s just to give you a hint at the power of options to generate income. When trading options, you can be bullish, bearish, or neutral. You can change the degree of outlook and the amount of risk and reward you’re looking for. And in all cases, you can turn them into income producing strategies. None of these are possible by using shares of stock alone. It’s only for those who understand the option advantage.

7 OPTION ADVANTAGE #7: PORTFOLIO PROTECTION

Stock investors usually hold portfolios concept called portfolio protection, and of stock, mutual funds, and possibly there’s no way to get it with any asset bonds. In all cases, it’s possible to take other than options. It’s another option extreme losses, no matter what mix of advantage. assets you’re holding. To use portfolio protection effectively, If you buy many different sectors, you’ll you should have a portfolio of several get diversification, but that doesn’t help stocks, say at least five or so. If you when markets crash – everything drops. have fewer, it may be easier to just Diversification helps if a certain sector buy puts on the individual positions. falls, but not when the entire market We’re going to outline the idea of goes over the edge. How can you portfolio protection so you can protect your entire investments from appreciate the option advantage. Most precipitous falls? advanced options platforms will do all the following calculations for you. Some investors who know a little bit It’s just a matter of clicking “buy” and about options understand that you can the number of contracts you need. To buy put options to act as an insurance gain an appreciation for what these policy against the long shares. If you platforms are doing, let’s start with the own 300 shares of IBM at $160, for fundamental necessary mathematical instance, you could buy three put concept called beta weighting. options as an insurance policy. If you buy three $155 puts, you have the right, not the obligation, to sell your 300 BETA WEIGHTING shares for $155 thus limiting your losses to the $5 difference. In a sense, buying Most stocks tend to follow the overall out-of-the-money puts is like accepting market, say the S&P 500 index. If the a deductible. It represents a certain index is up, most stock prices are up, level of losses you’re willing to accept and if the index is down, most stocks before the puts begin to block the are down. However, the degree they losses. If you buy even further out-of- rise or fall will be quite different. If the the-money puts, such as the $150 puts, S&P 500 is up 10% at the end of the you’re accepting a large level of losses year, some stocks will be up far more, – a large deductible. And just like the and some far less. world of insurance, you’ll pay less too. That’s another way of understanding Some stocks tend to move in the why lower-strike puts are cheaper. opposite direction of the market. When the market’s up, they tend to fall and What most investors don’t know is that vice versa. you can use puts on a single index to protect an entire portfolio, regardless of the stocks you’re holding. It’s a

There are mathematical ways to IBM would be expected to match that measure these movements, and it’s number roughly by beta, or about 96%. called the stock’s beta. By definition, the If the market is up 10% at the end of the S&P 500 index always has a beta of 1.0. year, you’d expect IBM to be up 10% * It never changes. If the market moves 0.96 beta, or about 9.6%. If the market’s up a given percentage and a particular down 20%, IBM will be down about stock typically rises twice that, its beta 19.2%. IBM is therefore just ever-so- will be 2.0. Again, this doesn’t mean the slightly less volatile than the S&P 500. stock always moves exactly twice that of the index; it just tends to do that over To use portfolio protection, you’re time. If the beta is 0.5, the stock tends using the concept of beta to find an to move by half the amount. effective beta for the overall portfolio. It’s easy to do, with just a few steps. A positive beta means the stock Most options trading platforms will do usually moves in the same direction the calculations for you, but it helps to as the overall market. A negative beta go through the motions to understand means the stock usually moves in the what’s happening. opposite direction of the market. Beta is a long-term mathematical concept, First, take the dollar value of all your so it doesn’t necessarily hold at the stock positions and add them up. This is end of the year, and definitely not in the overall portfolio’s value. Take each the day-to-day fluctuations. Below is position’s dollar value and divide by the a screenshot from the OptionsHouse portfolio’s value to get each positions platform showing IBM’s beta: percentage value. These percentages provide the “weights” for the portfolio. By taking the percentage of each position and multiplying it by beta, you get the portfolio’s overall beta weight.

SOURCE: OptionsHouse. Market Rebellion is not endorsed by or affiliated with OptionsHouse. For illustration purposes only. Not a trade recommendation.

A beta of about positive 0.96 means that IBM usually moves in the same direction as the market, and tends to match it by about 96%. No matter what the index change is at the end of the year (or other longer-term time frame)

As a simple example, assume you have the following four positions:

PERCENT OF STOCKS DOLLAR VALUE PORTFOLIO BETA BETA* PERCENT A $10,000 10% 1.2 0.12 B $20,000 20% 1.8 0.36 C $30,000 30% 2.0 0.60 D $40,000 40% 1.3 0.52 Sum = $100,000 Sum = 1.6

The entire portfolio is worth $100,000, Because each option contract controls so each stock makes up 10%, 20%, 30%, 100 shares, buying one put would over- and 40% respectively. If you multiply insure the portfolio since you’re buying each of those percentages by its beta insurance covering 100 shares even and add them all up, you get 1.6, which though you only own 67 shares. To is the portfolio’s overall beta weight. make it easier, we can use the SPY index Now that you have the portfolio’s beta, instead, which is 1/10th the level of the you need to figure out the effective S&P 500, which makes the number of number of shares of S&P 500 that shares increase ten-fold. Overall, our it’s covering. portfolio is behaving like 670 shares of SPY. To do so, take the level of the S&P 500, which is currently 2,388. Take the Because we’re now controlling more $100,000 portfolio value and divide than 100 shares, it’s easier to hedge. by 2,388, which gives you 41.87. In We can buy six put options on the SPY other words, for that money, you could and be a little under-insured, or we can buy about 42 shares of the S&P 500. by seven contracts and be slightly over- However, if you did, it doesn’t mean the insured. The main idea to understand portfolio will behave like 42 shares – the is that beta is the mathematical beta is greater than one. To account for connection that allows investors to the beta, multiply the 42 shares by the match their portfolio to the S&P 500 1.6 beta, and we get 67.2. What does index, or any index of their choice. this mean?

It means that mathematically, this portfolio of four stocks is behaving about like 67 shares of the S&P 500 index. If that index rises of falls one dollar, you’d expect this portfolio to gain or lose about $67 in value.

Below is a screenshot of the OptionsHouse platform showing just how easy it is to beta weight your portfolio. It contains five stocks ranging from $10k to $50k in value. In the red box, you type the index you want to use to weight the entire portfolio against, which is the SPY in the example. In the blue box, we get the result, which is shown as the effective “delta,” or equivalent number of shares. The entire process takes a couple of mouse clicks and all calculations are done for you. In the example, this portfolio is behaving like 455 shares of the SPY. If we buy four puts, we’ll be a little under-insured, and if we buy five we’ll be a little over-insured. Depending on the strike, you can alter the amount of the “deductible” and risk you’re willing to assume. Options make it all possible.

SOURCE: OptionsHouse. Market Rebellion is not endorsed by or affiliated with OptionsHouse. For illustration purposes only. Not a trade recommendation.

The advantage of beta weighting is that you can quickly insure your entire portfolio in seconds. It’s also much cheaper than buying puts on each individual stock,

especially when markets get turbulent services, which are designed for long- quickly. By beta weighting, it’s one term investors who want to remove single trade to place insurance on the the fear of crashes, but make money if entire portfolio, and one trade to take the market falls about 5% or more. No it off. It couldn’t be any easier, and it’s matter what your investing style, if you only possible because of beta weighting want to insure your portfolio for varying – one of the many option advantages. amounts, there’s no way to do it other than with options.

LONG-TERM INVESTING Portfolio protection can be amplified by using the Stock Replacement strategy, Portfolio protection is a big benefit for which we briefly covered in Option all long-term investors. When market Advantage #1. The idea is to use a deep- conditions get rough, it’s easy to get in-the-money call rather than shares of nervous and close your positions – only stock. Doing so means you spend less to find the market making new highs – money, but control the same number over and over. However, when you’re of shares. The extra money can be used using portfolio protection, the fear for buying portfolio protection, so for is removed, and it allows you to stay the same money, or even less, you can focused on your long-term goals. control the same number of shares with the same unlimited gains – but Without getting too complex, you have a greatly limited loss. The added can even structure your portfolio so cash can also be used to buy shares on that you’ll actually make money if the unexpected dips – money you wouldn’t market drops by a given percentage or have had by using shares of stock. more. It’s what we use in our trading

INSURED PORTFOLIO

With an insured portfolio, you’re setting The red curve shows the distributions up a powerful tradeoff in risk and for an uninsured portfolio. The gains reward. The insured portfolio will have are potentially higher, and so are a greatly limited potential loss – once the losses. The blue curve, however, the index falls below a given level, your shows the distributions for an insured portfolio stops taking losses. Again, that portfolio. Once the portfolio falls to a level can be set anywhere you’d like, but certain level, say to 90% of its current you’ll always face the overall risk-reward value (a 10% loss) no more losses can market tradeoff. If you want more be incurred. The bell curve hits a dead protection, you must sacrifice some end, which is why the blue curve is future gains. The chart below shows truncated at the 90% level: two hypothetical bell curves.

0.9

0.8

0.7

0.6

0.5

0.4 Probability 0.3

0.2

0.1

0 70% 80% 90% 100% 110% 120% 130% Portfolio Percent

The insured portfolio will have more won’t experience the same potential consistent returns near the center of for high returns, you’ll also never get hit the bell curve. with large losses. The portfolio returns are forced near the center of the bell While your upside gains are still curve. An uninsured portfolio will have a theoretically unlimited, the underlying better probability for higher returns – at stock prices must rise even higher the risk of accepting larger losses. to match the gains of the uninsured portfolio. The reason is that you must Portfolio protection is important for pay for the options, which means you’re another reason: It clearly shows that it’s effectively more for your shares, so incorrect to say that options are risky. your returns are reduced. So while you Here, we’re using them as an insurance Level Up Your Trading - CALL NOW: 866-443-8018 56 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

policy. It’s possible the traders selling However, it’s also possible the put these puts are acting recklessly and sellers are using them as insurance hoping for a big market drop – and a against a short stock portfolio and big payoff. Just because some people acting just as prudently. Options allow choose to use options in this way traders to adjust risk-reward levels to doesn’t mean that all traders are more match their market outlooks and speculating. risk tolerances. Portfolio protection can only be done by using options. It’s one more option advantage.

8 OPTION ADVANTAGE #8: LOCK IN PROFITS

Profits and losses are powerful naysayers and doubters must bow motivators. Fear and greed are to this advantage because there’s no stronger. The problem for most retail better way to manage risk. investors is that they’re so fearful of losing money that they sell at the first For example, let’s say you bought 500 sign of profits. To make matters worse, shares of stock for $50 per share. If the they despise losses so much that they stock price rises, especially significantly, would rather attempt to gamble their the temptation is to sell and collect way from losing positions. When prices the profit before the market makes a fall, stock investors are inclined to hold, monkey out of you. Nobody likes to buy more shares, and make other bad take losses, so the best defense is to decisions hoping that the stock turns collect when there’s profits. It seems around. Hope is not a good strategy. like the right thing to do but it’s a big To succeed with investing, you must misconception. Trends last much longer get out of the short-term fear factor than investors suspect. When you see of adverse price moves and be able a stock trading at an all-time high, to hang on through the noise – and it’s usually much higher six months capture the big profits waiting at the later. Those are the critical profits that end. It’s easier said than done – until investors miss, and it’s all because you use options. Options allow you to of fear of losses. Can you split the manage where the risk is – not where difference and sell some of your shares? you think the risk ought to be. Sure, but now you’re shrinking the size While options provide many of the position. If the stock price rises, advantages, probably the biggest and you might choose to sell 100 shares, most powerful is the ability to lock in but now you’re holding 400, not 500. If profits – but still stay in the position. it rises more and you sell another 100 It sounds impossible since that’s shares, you’re down to 300. Eventually, something stock investors cannot do. you’ll run out of shares. Because trends It’s not an impossibility; it’s the option last longer than investors expect, you’ll advantage. Even the biggest options still find this partial-selling strategy

leaves you missing out on most of the one. What does the roll-up accomplish? profits. Maybe it’s better to buy, hold, and forget about it? In the introduction, we said that for any expiration month, lower-strike calls Not at all. Stocks can take big must cost more than higher strikes. unexpected hits. Even though many That’s because a lower strike gives eventually bounce back, even if months you the right or years later, the shock of the fall to pay less for usually makes investors sell. Some the shares, so RISK MANAGEMENT 101 may buy more shares – only to find there’s more it falls further. To buy, sell, or hold is intrinsic value. the nagging question for all investors. No matter what MANAGE THE RISK, Options solve the problem. It’s the your $100 call is NOT WHERE YOU option advantage. worth, the $105 call with the THINK THE RISK same expiration OUGHT TO BE. ROLLING FOR PROFITS must cost less money. Let’s say Options trader can use a technique it’s trading for called rolling. By rolling an option, you $10. lock in profits, but maintain the same sized position. Here’s how it works: Now think about the transactions: If you sell your $100 call, you’ll receive the $14 Let’s assume you buy a six-month $100 market price. You’ll take some of that call for $10. The most you can lose is cash and buy the $105 call. This leaves the $10 paid, so you instantly have you with cash left over – but still owning downside protection that you wouldn’t a call option to participate in further have with the shares of stock. Later, upside gains. It’s a great hedge against the stock rises, and the $100 call is risk because the cash sits safely in your now trading for $14. Again, most new money market and can never be lost if traders would be tempted to take the the stock price falls. profit by focusing too much on the 40% ROI. It seems hard to pass up. The transactions would look like this: You’d hate to see that turn into a 100% loss rather than taking the 40% gain. Sell $100 call = +$14 But professional traders will, instead, Buy $105 call = -$10 execute a roll up. By rolling up, it means Net credit = $4 you’re selling your current $100 call, but buying a higher strike, say the $105 Without getting into the details, it’s strike. usually best to roll when you can capture about 80% of the difference in strikes. Both orders can be entered into your In this example, there’s a five-dollar broker’s platform as a simultaneous difference in strikes, so you should roll transaction, which means both orders when you can capture about 80% of that are executed as one. There’s no risk of difference, or $4. having one order fill, but not the other Level Up Your Trading - CALL NOW: 866-443-8018 58 Copyright ©2020 Market Rebellion, LLC. All Rights Reserved. THE OPTION ADVANTAGE

If you sell the $100 call for $14, but buy the $105 call for $10, your net credit from the transactions is $4. It’s this credit that helps to reduce your overall risk. Prior to the roll, you paid $10 which was your principal. One of the first rules of risk management is to guard that amount. After the roll, you collected $4, which means your net investment is now $6.

However, you still control 100 shares of the underlying stock! Unlike a stock investor who must sell shares and end up reducing his position, an options trader doesn’t have that problem. Options traders can always control 100 shares of stock – but continually collect credits when the stock moves in your favor.

If you continue rolling, you’ll eventually receive more in credits than you initially spent on the position. You’re now into a position that can’t lose – but still own a call. The fear of losses is gone, and you can continue riding the position for further profits, but still be guaranteed to have a great return on your money – even if the stock price falls.

Here’s what the transactions look like from a profit and loss standpoint. Your initial purchase of the $100 call for $10 means you can make an unlimited amount if the stock price rises, but only lose $10 if it falls:

Long $100 Call for $10 $20

$15

$10

0 Profit/ Loss Profit/ 85 90 95 100 105 110 115 120 125 -$5

-$10

-$15 Stock Price

After the stock price rises, you rolled to the $105 call for a net credit of $4, which reduces your net investment from $10 to $6. If the stock takes a turn for the worse, the most you can now lose is $6 rather than $10. The $4 credit acts as a hedge. Notice how the resulting profit and loss diagram is raised from a maximum loss of $10 (blue line) to now only $6 (red line):

Long $100 Call Rolled to $105 Call for $4 Credit $20

$15

$10

0 Profit/ Loss Profit/ 85 90 95 100 105 110 115 120 125 -$5

-$10

-$15 Stock Price

Even though the roll reduces your downside, it’s not without a tradeoff. By rolling to the $105 call, you have the right to pay $105 rather than $100, which is a $5 cost. However, the $4 credit is cash in your pocket. So your breakeven point is raised by the one-dollar difference.

For the initial trade, buy the $100 call for $10 created a $110 breakeven point at expiration. After the roll, you own the $105 call for an effective cost of $6, which makes your breakeven $11. That’s why the red line above has a breakeven point that’s one-dollar higher than with the $100 call (red line sits one-dollar to the right).

It’s a small amount to give up, considering what you’ve done to manage the downside risk. Notice that the $105 call (red) can only lose a maximum of $6 now rather than the $10 that could have been lost prior to the roll. This risk reduction is the reason for the roll. Shifting the breakeven point a touch higher is a cost, or tradeoff of the roll. What happens if the stock price continues to rise?

Continue to roll! Always stay with the trend. There’s no reason to get out of the position early when you can continue to roll, reduce risk, and capture greater profits without the fear of losses. Let’s say your current $105 call continues to rise from $14 to $18 and the $110 call is selling for $14. You can now capture another $4 by rolling to the $110 strike:

Sell $105 call = +$18 Buy $110 call = -$14 Net credit = $4

As before, the credit sits as cash in In most cases, however, expect to have your money market account, so you it three or four rolls. can’t be lost if the stock suddenly turns south. So far, you’ve collected $8 from You can use other tactics to get yourself both rolls, so your initial $10 investment into this position too. For example, if is now reduced to $2 – but you can still you owned 10 $100 calls and wanted to capture unlimited upside gains: roll to the $105 call, you could sell six The goal of rolling is to eliminate the contracts to close and roll the remaining need for trying to decide when to sell. four. That brings back all of your money Instead, make the decision easy. Stay in and you own four $105 calls for free: the position but reduce the fear – roll, roll, roll! Eventually, you’ll end up with Sell 6 calls at $14 = +$8,400 credits totaling more than your initial Roll 4 calls at $4 = +$1,600 investment. At that point, your profit Total credit = $10,000 and loss curve has shifted completely above zero: Rather than taking several rolls to get all your money back, you’ve now done it in When your profit and loss curve has one. Rolling is perhaps the single best been shifted above zero, it’s like being option advantage because it allows you paid to own the call. If the underlying to control the same-sized position but stock happens to make a large move continually reduce the risk. over a short time, you may be able to roll into a zero-cost position in one roll.

Long $105 Call Rolled to $110 Call for $4 Credit

$25

$20

$15

$10

0 Profit/ Loss Profit/ 85 90 95 100 105 110 115 120 125 130 -$5

-$10

-$15

Stock Price

ROLLING DOWN

As with all options strategies, what’s good for the bulls is good for the bears. If you’re bearish and buying puts, you can roll puts to collect profits just as you can calls. The difference is that, for puts, you execute a roll down. By rolling down, you’ll roll to a lower strike put. For any expiration month, higher-strike puts will always be more expensive because they give you the right to sell shares at a higher price. Let’s assume the $100 call in the previous section was, instead a $100 put for $10. The initial profit and loss diagram would look like this:

Long $115 Call Rolled to $2 Credit

$25

$20

$15

$10

$5 Profit/ Loss Profit/ 0 95 100 105 110 115 120 125 130 135 Stock Price

If the underlying stock falls, you could roll it down to the $95 put, for example. Let’s say the stock falls and the $100 put is now trading for $14 and the $95 put is trading for $10. The roll-down transactions would look like this:

Sell $100 put = +$14 Buy $95 put = -$10 Net credit = $4

It’s exactly the same idea as rolling up a call, for exactly the same reasons, just in the opposite direction. Your profit and loss diagram has now moved from the initial $100 strike (blue line) and a possible $10 loss, to the $95 strike (red line) and a possible $6 loss:

Long $95 Put for $4 Credit

$20

$15

$10

$5 Profit/ Loss Profit/ 0 70 75 85 90 95 100 105 110 115

-$5

-$10

-$15 Stock Price

Just as for the calls, the breakeven point is pushed a little further away. When you bought the $100 put for $10, your expiration breakeven was $90. After the roll, you’re effectively holding the $95 put for $6, which makes your breakeven $89. That is, you need the stock to drop by an extra dollar by expiration to break even on the trade.

However, the reason for doing the roll was to reduce the amount that could be lost, and the roll reduced the maximum loss from $10 to $6. By rolling the put to a lower strike, it allows you to remain in the same-sized position, hold on for bigger profits, but continually reduce the amount of total loss. It’s something a short-stock trader can never do.

Long $100 Put for $10 $20

$15

$10

$5 Profit/ Loss Profit/

0 70 75 85 90 95 100 105 110 115

-$5

-$10 Stock Price -$15

THE PROBLEMS WITH THE OPTION ADVANTAGE

TRADING STOCKS Like stocks - options let you profit by the market, and leverage your time and Stock market investing is one of the money. But beyond that, options give easiest ways to put your dollars to work, you the power to: leverage your time, and let money make money. • Control losses and lock in profits • Actively manage/limit downside risk Unfortunately, many investors turn this • Gain leverage & increase your ROI money-making machine into a paper • Leverage more ways to profit shredder for one reason – fear. With each market downturn, they panic No matter what type of long-term and sell for large losses. They believe investing you do, no matter what type they’re doing the right thing, but they’re of short-term speculation you seek, digging deeper holes: Those losses there are options strategies that CAN must eventually be recovered from help you meet your goals IF you know future investments, and that means the how to apply them. That’s where Market game gets harder and harder as losses Rebellion can help. mount. GET THE OPTION ADVANTAGE - Plus, when buying stocks – it’s all or CALL 866-443-8018 nothing. Yes, you can make 100% of the returns but it entails you putting for a Free Consultation with one of yourself at risk for 100% of the losses. our trading coaches Those are the types of extreme outcomes you want to avoid.

Take the next step today. Call 1-888-982-8342