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Rule One Transformational Investing - Webinar #4
Rule One Transformational Investing - Webinar #4
Rule #1 Transformational Investing Course
1) Rule #1 Investing through the 4Ms
2) Payback Time and 10 Cap Rate Valuations systems
3) Analysis of a Wonderful Company from A-Z
4) How Options work and how we use them
5) A Rule One Put (ROP) and Rule One Call (ROC)
6) How Technical Indicators work and how we use them
7) Rule #1 Short Term Trading rules and strategies
8) How Credit Spreads work and when we use them
9) Risk Management and managing a trade gone bad
10) RUT Expiration Day BPS System Trade and Money Management
11) Rule One Short Strangle (ROSS) and other Ruler combination trades
12) Lowering Cost Basis and Creating Equity Bonds
13) Review and Q&A from real trading experience
Webinar #4 – Basic Options
• Why Rulers use stock options
• Stock option contract defined
• Rights and obligations of option contracts
• Selling PUTS (ROP) and CALLS (ROC)
Options: Advantages & Disadvantages
Advantages of Options• Leveraged returns
• Flexibility for profits in any type of market
• Increase the rate of return on your portfolio
• Minimize capital at risk
• Generate income on the stocks you own
• Hedge your portfolio from losses
Disadvantages of Options• Leveraged losses• Limited by time – must be right, right now• Complicated
Options – Rule One Style
Rule One Investors use options for three reasons:1) To enter into a long term investment on a Wonderful
Company at or near the “Green Zone” (MOS/PBT price). This is a Rule One Put (ROP).
2) To exit from a long term investment on a Wonderful Company that is in or near the “Red Zone” (20% above the Sticker Price) This is a Rule One Call (ROC).
3) To make short term trades on any security to produce extra profits each month. This is a Credit Spread.
This lesson will just explain the methods of using options for entering and exiting from a long term investment on a Rule One stock (ROP and ROC).
Option Basics
• Every new endeavor has some sort of unique language associated with it.
• Once you learn that language, your experiences in your new field or area becomes a more enjoyable and successful experience.
• Options are no different –
once you learn the basic language,
you will find the mechanics and
strategies easy to follow.
Options Defined – Key Terms
• Option Contract - one contract controls100 shares of stock (not stock ownership).
• Options are contracts that are sold and bought at a price called a “premium”.
• Option contracts define the right to buy and sell shares at specific prices during a specific period of time.
• The option contract is NOT the actual shares of the underlying security.
• Each contract controls 100 shares of the underlying security. Two option contracts would control 200 shares. Five option contracts would control 500 shares.
Options Defined – Key Terms
– The buyer pays a premium and gets rights– The seller gets paid a premium and has obligations – The buyer has the right to exercise the contract to buy (CALL) or sell
(PUT) shares.– The seller may get assigned the contract and have to buy (PUT) or
sell (CALL) shares.– An option derives its value from the underlying security. The price
(premium) of the option is effected by the price movement of the underlying security and how much time is left in the contract.
• Stock Option: Buying an option is the RIGHT, but not the obligation, to buy (CALL) or sell (PUT) a specific stock (called the underlying security) at a set price (called the strike price) on or before a specific date (called the expiration date).
Insurance Policy Contract Analogy
• Stock options are much like an insurance policy.
• The buyer of the policy (the insured) pays a premium and gets certain rights for a certain period of time.
• The seller of the policy (insurance company) writes the insurance contract and gets paid a premium to be obligated to perform in certain ways under certain conditions.
Options Defined – Strike Price
• The strike price is the agreed on price that the stock will be bought and sold at.
• This is not the current price of the stock but the contractual price the shares must change hands at if the contract is assigned.
• IF shares change hands, they change hands at this price.
Options Defined – Key Terms
Premium: Every time you buy an option what you are paying is referred to as the premium. Every time you sell an option what you receive is also referred to as the premium.
As a trader in options, you are trading the option premium – not the underlying security. The two are separate but the price or premium of the option is effected by the underlying security and its price movement.
The premium is made up of two aspects:Intrinsic and Extrinsic Value
Stock Price
-Strike Price
Intrinsic Value
Time Value
+Implied Volatility
Extrinsic Value
Intrinsic Value
+ Extrinsic Value
Premium
Options Defined – Key Terms
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Expiration Date: This is the date and time for which the option contract will cease to trade and then expire.
The expiration for stock options occurs on the Saturday following the third Friday of the expiration month.
Because the market is closed to trading on Saturday, the last day to get out of an expiring stock option is the third Friday of the expiration month.
Options Defined – Key Terms
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Bid-Ask Spread: The Bid-Ask spread is the difference between the price at which the option is bought and sold. In this case: $0.30
With a Market Order, the seller gets the BID price and the buyer gets the ASK price. The Spread goes to the Market Maker as a commission.
We usually place a Limit Order at the Mark (half way between BID and ASK) to reduce our trading cost.
Options Chain on TOS
Options Chain: OTM, ITM, ATM
ITM
ITM
OTM
OTM ATM
Out of the Money (OTM) – For a CALL - the strike prices that are higher than the underlying security's price.For a PUT option – the strike prices that are lower than the underlying security's price. *No Intrinsic Value – only Extrinsic Value.
In the Money (ITM) – For a CALL – the strike prices that are lower than the underlying security's price. For a PUT option – those strike prices that are higher than the underlying security's price. *Premium has both Intrinsic and Extrinsic Value.
At the Money (ATM) – The strike price that is nearest the underlying security's present price.
Option Contract Buyer vs. Seller
• The buyer of a CALL has the right but NOT the obligation to BUY the stock at the strike price any time until expiration.
• The buyer of a PUT has the right but NOT the obligation to SELL the stock at the strike price any time before expiration.
• The seller of a CALL has the obligation to SELL shares at the strike price if the contract is assigned by the buyer.
• The seller of a PUT has the obligation to BUY shares of the stock at the strike price if the contract is assigned.
Buyer and Seller Can Exit Anytime
• Both buyer and seller may get out of the option contract at any time during the life of the contract.
• The buyer Bought to Open (BTO) the option so if they want to get out of the trade, they just Sell To Close (STC).
• The seller Sold To Open (STO) the option so if they want to exit the trade, the just Buy To Close (BTC).
• The profit or loss on the trade will be determined by how much the premium of the option contract has changed since the trade was opened.
Call and Put Options
• All option strategies have one or more of the following actions:
– Buying a Call
– Selling a Call
– Buying a Put
– Selling a Put
Selling PUT Options
• Common Use by Speculators: When traders expect the underlying stock to move up in price or stay the same.
• Rule #1 Use: To lower our basis on stocks that we would like to own at the price we want to own it. As a default, if the stock is not put to us, to generate cash flow.
• Maximum Risk: Limited only by the stock going all the way down to $0.
• Maximum Risk for Rule #1 Investor: Since we only sell PUTS on stocks that we know are Rule One companies, at a large discount to their Sticker Price, it has very low risk.
• Maximum Reward: The credit received for the trade or the Wonderful Company purchased at our “buy price.”
• Time Decay: Works in favor of the seller’s trade.
Working with Options Chain
• Demonstration of how to sell a ROP on TOS
• Let’s assume that we seek to acquire shares in CBI at MOS = $22.00
• Let’s look at June contract and October contract.
• For each contract month, what is the strike price we need to achieve net acquisition cost of $22 or lower?
Selling Call Options
• When Commonly Used: When traders expect a short-term drop in the price of the underlying stock.
• Rule #1 Use: To generate cash flow on Rule #1 stocks you own (AKA COVERED CALLS) or to exit an over-priced stock with a nice bonus to the present stock price.
• Maximum Risk for Speculators: Limited only by the stock going all the way down to $0.
• Maximum Risk for Rule #1 Investor: If sold in the Red Zone, and called away, none. If sold lower than the Red Zone, opportunity cost on price appreciation of the Rule One stock.
• Maximum Reward: Credit received for selling the CALL + capital gain from your Cost Basis to the Strike Price.
• Time Decay: Works for the seller’s trade
ROP and ROC tactics
• ROPs are part of our entry tactics into long-term investment on a Wonderful Company.
• ROCs are part of the exit tactics after the Wonderful Company has doubled its price (normally 3-5 years later).
• Both ROPs and ROCs can generate cash flow.
Trading Terms
• BTO = Buy to Open
• STC = Sell to Close
• STO = Sell to Open
• BTC = Buy to Close
• Limit Order vs. Market Order
• Day Order vs. GTC (Good till Cancelled)
• Bid, Ask, Spread, Mark
• Portfolio Margin vs. Standard Margin vs. Cash Settled
Option Terms - REVIEWED
• Option Contact: 1 contract = 100 shares of an underlying security that change hands at the Strike Price IF the contract is assigned.
• CALL rights and obligations• PUT rights and obligations• Strike Price • Days To Expiration (DTE) • Contract Assignment vs. trading the contract to someone else• ATM = At The Money• ITM = In The Money• OTM = Out of The Money• Intrinsic Value = Difference between Strike Price and Market Price• Extrinsic Value = Time + Implied Volatility
Webinar #4 – Review
• Why Rulers use stock options
• Stock option contract defined
• Rights and obligations of option contracts
• Selling PUTS (ROP)
• Selling CALLS (ROC)
HOMEWORK
• Pick your “Just One,” Rule One company that is closest to being on sale (MOS or PBT).
• Go to the ThinkOrSwim (TOS) options chain for that stock (use the Trade tab). Be sure you are in TOS Paper Money.
• Pick the contract month and PUT strike price that will give you a “Cost Basis” that is closest to your MOS/PBT if you get put the stock. Make adjustments to your trade (Strike Price and Contract Month) to get the best combination of results for both goals: Cost Basis at or near the MOS/PBT.
• Sell To Open (STO) the PUT contract in the TOS Paper Money.
• Send your results to Andy at: [email protected]
