Introduction to Options – Buying Call Options

Students that attend Rich Dad Education elite trainings are taught numerous advanced options strategies. Rich Dad Education students that obtain a personal mentor are further taught how to choose and refine these strategies to fit their trading style and their personal financial objectives. As students become aware of new option strategies, they often get excited about incorporating them into their trading.

While the prospect of learning new option strategies can be very exciting, it also involves learning how various options work with one another. Many spread option strategies involve the simultaneous buying and selling of different options at different strike prices. In time, the execution of such option strategies becomes second nature to traders, but in the beginning it can be a bit confusing. One thing Rich Dad Education students new to trading should always remember is that all option strategies are made up of one of four building blocks. Once traders understand these building blocks, then the profitable execution of any option strategy is within their reach.

All option strategies are comprised of one of four different actions:

1. Selling a call
2. Buying a call
3. Selling a put
4. Buying a put

These choices can be combined into numerous option strategies, but you should never forget that the core building blocks are simple and straightforward. Once you understand how each of these options work, then more advanced strategies will become surprisingly easy to grasp.

Buying Call Options

The simple buying of a call is many trader’s first entry into the option world. It is not uncommon even for individuals with no training to buy a call because “they think the stock is going to go up.” While Rich Dad Education students gain a much deeper understanding of how to identify when a stock is likely to increase in price – at its most basic level, call options can be purchased when there are signals that a stock’s price is going to go up.

Buying a Call

• When Commonly Used: When traders expect the underlying stock to move up in price.
• Call Buyer’s Rights: To buy a specific stock for a specific price (strike price) during a specific period of time (on or before expiration date).
• Maximum Risk: The price of an option premium. You can lose 100% of your investment.
• Maximum Reward: Unlimited.

Let’s use a simple explanation to illustrate when many traders buy calls.

You are extremely bullish on company XYZ. The company has been trending upward for months and has hit resistance at the $50 level twice in the last week and a breakout pattern appears to be occurring. Your analysis of the chart shows that once the stock breaks through the $50 ceiling on volume, there could be significant movement upward. Of course, as a disciplined technical trader, you wait for your trigger (i.e., when the stock breaks the ceiling on volume) to enter the position. When you want to enter a trade with a call, you must make three immediate decisions:

1. At what price do you want to purchase the option (the strike price)?
2. In what month do you want the option to expire (the expiration month)?
3. How many contracts do you wish to purchase?

In this situation, the buying of a call is one trading strategy that can allow you to capture the upward movement of the stock. In this call example, you are just looking to short-term trade the stock and decide to use a call option as a means to your trade. You decide to:

• Purchase the $50 strike price
• Choose an expiration date two months out
• Purchase one contract

This allows you to buy 100 shares of the stock at $50 any time before the expiration date you have chosen. Remember that as the call buyer you are not forced to buy anything in the future, you simply have the right to do so at any time if you so desire.

In most cases, you have no intention of actually buying the stock if it goes up in price. You are simply interested in how much your option goes up as you will likely sell back that same option at some point, and hopefully at a profit! Your call options value will fluctuate as the underlying stock goes up and down, and you have the ability to sell the call option back at any time you choose before the expiration date on your option.

Let’s assume the breakout performs as anticipated, and the stock rallies higher to $60. The call option that you purchased will become more valuable because you still have the right to buy the stock at $50. It doesn’t matter how high it goes as the seller of the option contract is obligated to sell you the stock at the agreed upon price.

This is just one situation in which you can profit from a call option. In the next article in this Rich Dad Education series on options, various setups will be discussed that can be used in conjunction with call options.

Introduction to Options – Liquidity

In the previous article in this Rich Dad Education Introduction to Options series, the bid-ask spread was discussed. It is important for new Rich Dad Education students to have a firm understanding of the bid-ask spread for two reasons. First, understanding the bid-ask spread can potentially save you transaction costs on your trades by knowing you can get better prices from the market makers. Over time, the little saved on transaction costs can start to add up and represent significant savings. Second, and perhaps more importantly, when a Rich Dad Education student understands how the bid-ask spread works, they gain greater insight into how the market works. Once you gain a full understanding of how the market works, you come one step closer to becoming an elite trader.

Options Liquidity

Understanding the concept of liquidity and how it affects your trading is an important early step for Rich Dad Education students new to trading. As you start to study charts, you will see potentially good trade setups that you may want to trade. In a perfect world, once you identify the entry point to one of these trades, you want to get in at the ideal entry point and the best price possible. Conversely, when you identify the moment to exit a trade, you want to act at the ideal exit point and get the best price as well. Understanding liquidity can help you achieve these ideal circumstances.

Liquidity for options traders is the ability to get quickly into or quickly out of a position that has a very small difference between the bid and ask. A highly liquid market has an abundance of buyers and sellers, allows orders to quickly be filled and enables traders to easily exit their positions. Because of this, some traders establish rules that only allow them to trade options on stocks that have certain volume requirements. These requirements will vary according to the trader, but common standards include 500,000 or one million shares in average volume daily. The higher the volume, the more liquid the option contracts will be.

Liquidity on Option Contracts

In addition to identifying volume on a stock, there are several other ways to identify whether the particular option contract you want to trade is highly liquid. These additional methods include option volume and open interest.

Option volume tells you the total number of option contracts that have been bought or sold for each and every strike price for the trading day. 

Open interest is another way to determine option liquidity. Open interest tells you how many open positions (contracts) there are in a particular options strike price. This is the total number of contracts that have been bought or sold and not closed out.

For example: Let’s imagine that you were the only individual trading a particular option strike price. If you purchased 50 contracts on a particular call option and were the only buyer, then today it would read:

Daily Volume = 50

The next day if the contracts were not closed out and you did not purchase any additional option contracts, then it would read:

Daily Volume = 0

Open Interest = 50

If a new trader came in and was interested in that particular strike price, they would see that there is indeed activity surrounding it. The higher the open interest, the more activity and potential liquidity there would be surrounding that option strike price.

High Open Interest – High open interest decreases the chance of market maker manipulation. It can also show that there is a lot of demand for a particular strike price. High open interest on calls over puts indicates that there may be a market bias towards the underlying stock.

Many traders have rules where they insist on at least 50 or 100 open interest before they will even entertain trading the option in question. Similar rules relate to the percentage of open interest that a trader owns, which usually is capped at 10%. When selling options you do not have to worry about open interest.

Even in the beginning stages, Rich Dad Education students need to take the time to understand liquidity and how it affects their options trading. While not common, there are horror stories of new traders that buy too many option contracts at a strike price that had little liquidity. The most frustrating of these stories involves new traders that were right about their prediction of the stock’s movement but couldn’t maximize their profit because there were no other traders interested in that particular option, and hence no liquidity. Take the time to establish a few simple rules that will help you avoid this frustration.

Of Chains and Teeter-Totters: Diversification

Diversification is trumpeted as an essential piece of the investing puzzle.  Financial preachers of all types and stripes admonish the retail masses to spread their investing eggs among all sorts of baskets to avoid losing too much money due to a single unforeseen basket drop.  And yet, it’s not enough to simply buy five different stocks or three different asset classes unless you know just how related they truly are.

Diversification without thoughts of correlation is folly.

Back in the day when I was fine-tuning my financial prowess, I would watch Jim Cramer’s Mad Money on CNBC to expand my vocabulary and better grasp how market veterans converse about investing.  One of the segments was called Am I Diversifed? and involved multiple callers spouting off their stock holdings then asking whether or not they possessed a diversified portfolio.  While many no doubt found Cramer’s responses enlightening, the reality is measuring diversification can be a simple task with the right tool – a correlation indicator.

The correlation study ranges between +1.00 and -1.00 with +1.00 representing a perfect positive correlation and -1.00 representing a perfect negative correlation.  If two assets have a +1.00 correlation it means they move in the same direction 100% of the time.  Each day asset A rises, so too does Asset B.

Like links in a chain positively correlated assets move in lockstep.

In contrast, assets boasting a -1.00 correlation move in opposite directions 100% of the time.  When one zigs, the other always zags.

In the financial playground these inversely related securities sit on opposing sides of the teeter-totter.

Finally, when the correlation study resides close to zero both assets in question have little distinguishable relationship. Which is to say the behavior of one offers little insight into the behavior of the other.

Source:  Stockcharts.com

Suppose an investor buys three different securities: SPY, MDY, IWM.  The SPY represents large-cap U.S. stocks, MDY represents mid-cap U.S. stocks, and IWM represents small-cap U.S. stocks.  Are they diversified?  Well, yes and no. Sure they own a mix of U.S. companies with varying size which on the surface appears diversified.  And yet all three ETFs have a strong positive correlation.  Odds are if one of them drops precipitously so too will the others.

A more diversified portfolio could be constructed selecting ETFs that boast a negative correlation such as stocks and bonds.  Correlation also plays a crucial part in the realm of intermarket analysis, but such is a discussion for another day.

Tyler Craig, CMT
Rich Dad Education Elite Training Instructor

Introduction to Options – The Bid-Ask Spread

In the most recent article in this Rich Dad Education series on options, elements of the options contract were discussed. Understanding the elements of an options contract is an important first step for any Rich Dad Education student interested in the world of options. Too many novice traders only have a partial understanding of options and are ill-equipped to succeed in their new endeavor. Rich Dad Education students are trained to have a complete understanding of the world of options so they can take advantage of all they have to offer. Part of this involves understanding the bid-ask spread.

The Bid-Ask Spread

When you trade, you are not trading in a vacuum but in a literal market. Every time you buy a share of stock there is a seller on the other end, and every time you sell a share of stock there is a buyer on the other end. The same applies to option contracts. For every buyer of an options contract there is a seller, and for every seller of an options contract there must be a buyer. To ensure that these buyers and sellers find each other, there are market makers.

Market makers not only assist buyers and sellers in finding each other but will oftentimes take on the rights or obligations for option contracts in order to provide liquidity to the market. They provide a valuable service to the market and, like any good middle man, the market maker gets their cut for facilitating the transaction. This cut is represented in the form of the bid-ask spread.

If you are new to trading, there are three components to the bid-ask spread that you should be aware of:

1. The Bid – The bid will always be a lower price than the ask on an options chain. It is the price that the market maker is willing to give you if you wanted to sell an option.
2. The Ask – The ask will always be a higher price than the bid on an options chain. It is the price that you would have to pay if you wanted to buy an options contract.
3. The Spread – The spread is simply the difference between these two prices. For example, if the bid on a particular option contract was $1.00 and the ask was $1.50, the spread simply refers to the $0.50 difference in price between these two numbers.

Beginner’s Note – If at first you are having a hard time remembering which price you receive when you buy or sell an options contract, then simply remember that you are always getting the less optimal price.

Key Points Regarding Bid-Ask Spread:

• Generally, the higher the volume on the stock/option, the tighter the spread will be. On highly traded stocks, the bid-ask spread will sometimes only be a few cents.
• Stocks/options that are thinly traded have wider spreads between the bid and ask.
• Be aware that the bid-ask spread is not necessarily set in stone and market makers will at times accept bids and asks that are within the bid-ask spread.
• When placing your entry/exit order, you can always enter a price between the bid and ask. This tactic reduces the cost of roundtrip transactions, which in turn increases the return. Buying a little below the ask and selling a little above the bid, generally somewhere between a 10 to 30% discount, will oftentimes result in the order being granted and the entry/exit order being filled.
• The tighter the spread, the less margin there is for the market maker, so the lower the discount should be.
• If a discount requested is greater than 30%, then you usually will need a price movement in the stock/option to have your order executed, or your order may not be executed at all.

As you begin your trading, it is wise to identify a few high-volume stocks to fill your initial watch list. There are many advantages to this, including tighter bid-ask spreads. If you identify a trade setup on a lower volume stock, it is important to be aware of the bid-ask spread and the impact it can have on the price you pay for the option contract and your ability to exit the trade at a profit.  In the next article in this Rich Dad Education series, this concept will be discussed further with the concept of liquidity.

Five Reasons New Stock Market Traders Fail

Experienced traders often envy the excitement and wonderment that the new trader experiences. Over the years, these experienced traders often develop systematic routines and have found the strategies that are best suited for their personalities and lifestyles. The veteran trader still enjoys their work, the flexibility of their job, and the profits that accompany it; however, their trading often becomes routine… even a touch boring at times. This boredom is usually the result of employing the same successful strategy, or taking advantage of the same successful trade setup, time and time again. The thrill that accompanied their early days may be long gone, but the veteran trader’s bank account has been well compensated.

It is hard to begrudge the veteran trader as they think about new traders as the early days, weeks, and months of trading are very exciting. During this early period new traders learn numerous concepts, develop charting skills and dream of original strategies. Often, a new trader will have a hard time falling asleep at night due to all of the ideas that are swimming around their head and thoughts of wealth just around the corner. These early days are indeed exciting, but few veteran traders would ever go back, no matter how tempting the thrill of doing it all over again may be. They wouldn’t go back because the reflective trader realizes the road to success in trading is a road that few traders are able to successfully travel.

When you read statistics on the percentage of traders who become successful, you get slightly varying reports. Sometimes you read that 90 percent of traders fail. Other times you read that 92 percent of traders fail to make money in trading. Sometimes you read that 94 percent of traders that attempt to become professional traders fail to do so. One can quibble over the statistics, but there are two truths that emerge out of all of these:

1. The vast majority of traders that start out will fail on one level or another.
2. While a much smaller percentage, there are traders who succeed.

For those new to trading, these two truths should simultaneously provide a great deal of comfort and a healthy dose of paranoia. They can take comfort in the fact that there are those that succeed and enjoy a level of prosperity that is life altering. They should also be aware and attempt to understand why so many traders fail so they don’t become yet another statistic.

There are numerous variables that can explain why traders fail, but there are a few common themes that emerge when examining failed traders. Here are some of the most common ones:

1) Lack of Education – It may seem self-serving for an education company to tell you that one of the most common reasons traders fail is lack of education, but it is the cold hard truth.  The school of hard knocks is very expensive when it comes to trading. Many traders attempt to go on their own after reading a few articles on the Internet or reading a book. Even if the material they read is factually accurate, it can seldom help a new trader put trading within context and develop a systematic plan that can help them succeed in the market. A proper education cannot only teach you the factual knowledge you need, but it can also help you create a step-by-step plan to approach each trade you make.

2) Money Management – Perhaps no reason why traders fail is more devastating than improper money management. If a trader lacks passion for trading, then they usually fail because they quit trying, but little financial harm is done. If a trader fails because of improper money management, then it can wreak havoc on their finances. Most, if not all, of successful traders have developed rules and guidelines for the percentage of their capital they can place on a trade and the percentage of capital they can have in play in the market at any given time. Unfortunately, it is far too common for new traders to overextend themselves on a given trade and only think of what happens if it goes right. When the trade goes south, they sometimes wipe out all if not a large percentage of their working capital.

3) Lack of testing – Time and time again, instructors and mentors will tell their students to test their knowledge of a strategy through virtual trading or through the back testing of a strategy. Time and time again, new traders will ignore such advice jumping into the world of trading with live money. An argument can be made that live trades are better teachers and this may be the case. However, many times new traders learn from these teachers at a very high cost when the same lessons might have been learned for free through virtual trading. If you are a new trader and insist on live trading right away, make sure that your trades are small so the lessons you learn are not expensive.

4) Lack of Plan and/or Focus – There are thousands of stocks and dozens of strategies that you can utilize to become successful. You can also choose numerous indicators to assist you and employ various trading styles. There is no universally correct way to trade and this becomes a problem for some new traders. One day they will learn about call options and trade these for a few days. Then, they will learn about the Iron Condor and trade that for a week. One day they want to be a swing trader and the next day a day trader. One day the MACD is the best indicator on the planet only to be replaced  by whatever indicator catches their eye next. While experienced traders can often use various trading styles and strategies to maximize their trading, they have gained the expertise needed to do so. New traders who jump around often fail to develop the needed expertise and are constantly making critical mistakes that lessen their chances of succeeding in the long term.

5) Improper Psychological Makeup – Some people are hampered by their own personality. Some traders are action junkies and are drawn to trading for the thrill of the action. New traders who are action junkies are usually severely punished as they are looking to trade, and not necessarily looking for great setups to trade. Other individuals cannot stand the thought of losing and exit trades too quickly or can never pull the trigger, no matter how great the trade setup may be.

It is amazing what a little patience, discipline, and self-awareness does to increase your chances of success in the world of trading. When you couple these attributes with a proper education, you will be well on your way to becoming part of the small percentage of traders who enjoy the tremendous rewards that trading can bring to their life.