Introduction to Options – Selling Puts

In previous articles in this Rich Dad Education series, three fundamental building blocks to option strategies were discussed: the buying of calls, the buying of puts, and the selling of calls. These building blocks are taught and reinforced in Rich Dad Education elite trainings. Understanding the mechanics of these building blocks and the appropriate use of each one is essential for traders wanting to use options. This article will cover the fourth and final option building block, the selling of puts.

Difference Between Buying and Selling Puts

When traders buy puts, they are anticipating a bearish move on the stock. The put buyer then has the right to sell that stock at the agreed upon price on or before expiration date. The hope for the put buyer is that the stock will fall in price so the premium they paid for their option will increase in value.

Traders should always be aware that there are two sides to every option. While put buyers have rights to sell the stock, the sellers of put options have the obligation to buy the stock at the same agreed upon price at or before the agreed upon expiration date. For example:

• Put Buyer: Pays $2.00 premium for $50 Put for March expiration
• Put Seller: Collects $1.90 credit for $50 Put for March expiration
• Market Maker: Collects $.10 for facilitating the transaction

In this scenario, the put buyer and put seller have agreed upon the $50 strike price in March. At any time before expiration, the put buyer may exercise the right to sell 100 shares of the stock at $50 per share. For this right, the buyer pays $2.00 per option contract. If assigned, the put seller has the obligation to deliver at $50 per share. For this obligation, the put seller receives a credit of $1.90 to their account per option contract. The market maker keeps the bid/ask spread of $.10.  Three scenarios can occur at this point at expiration:

1. The stock can stay above $50. In this case, the put seller is still obligated to buy the stock from the put buyer. Of course, the put buyer is not going to want to sell the stock for $50 when the market price is higher. The sold put expires worthless and the option seller makes his maximum profit of $1.90 minus commission.
2. The price of the stock at expiration will be somewhere between $49.99 and $48.10. In our example, the put seller received a $1.90 credit for selling the put option. If the stock is at $49 at expiration, the put seller is obligated to buy it at $50, but the total credit will still make the trade profitable. In this example, the put seller would net 0.90 per share. This is usually accomplished when the seller buys back the put option at the lower price. If not bought to cover, you will be assigned the stock.
3. The price of the stock at expiration will be below the put seller’s break-even point, in this case $48.10. The put seller is obligated to buy the stock at $50 no matter how low the current price of the stock is or the seller must buy back the option at a price that is higher for a loss. It does not matter whether the stock is $46, $40, or even $0.01. The put seller still has to purchase those shares at $50.

Selling Put Options – Review

1. You can sell a put: Some traders sell puts on stocks that they believe will go up in price or at a minimum stay at a price above the strike price they sold.
2. Selling a put is a credit trade: you receive a credit when you sell the put.
3. You have unlimited risk with selling puts.
4. You have limited reward from selling puts. The most you can make is your premium.

When Should You Sell Puts?

It is important to understand the mechanics of selling puts and the obligations associated with them. Gaining this level of comprehension will help you make sense of the world of options and will serve as a building block to learning option strategies that can be very helpful. While there are some advanced techniques to enter long-term investments where selling puts can be very useful, generally one should avoid the selling of puts. Selling puts carries with it tremendous risk due to the obligations associated with them. There are numerous other option strategies that can help you mitigate risk while still reap a tremendous return on your investment.

Introduction to Options – Selling Calls

The previous article in this Rich Dad Education introduction to options series discussed the risks associated with selling calls. Rich Dad Education elite trainings, mentoring programs, and other educational offerings can help students take advantage of selling options without taking on the enormous risk of simply selling call or put options. For this reason, credit spreads and covered calls are extremely popular topics covered in Rich Dad Education trainings.

If you choose to take advantage of the potential that credit spreads and covered calls can offer you, it is important to take the time to understand the fundamentals of selling options. The selling of calls is often referred to as naked calls because the call is unprotected from unlimited risk. While it’s possible you may never sell a naked call, understanding how they work will be very beneficial.

Naked Call Example

When traders buy calls, they are anticipating a bullish move on the stock. The call buyer then has the right to buy that stock at the agreed upon price on or before the specified expiration date. The hope for the call buyer is that the stock will rise in price so their option will also increase in value. If this occurs, the option buyer has two choices:

1. They can exercise the option, in which case they will buy the shares of the underlying stock and then sell it for a profit in the market, or
2. They can sell the option back at a profit

There are always two sides to every option. While buyers have rights to buy the stock, the sellers of call options have the obligation to sell the stock at the same agreed upon price at the chosen expiration date. For example:

• The stock is trading at $50 in the market
• Call Buyer: Pays $2.00 premium for $50 Call for March expiration
• Call Seller: Collects $1.90 credit for $50 Call for March expiration
• Market Maker: Collects $.10 for facilitating the transaction

In this scenario, the call buyer and call seller have agreed upon the $50 strike price in March. At any time before expiration, the buyer may exercise the right to buy 100 shares of the stock at $50 per share. For this right, the buyer pays $2.00 per option contract. If assigned, the call writer has the obligation to deliver 100 shares per option contract to the buyer at $50 per share. For this obligation, the call seller receives a credit of $1.90 to their account per options contract. The market maker keeps the bid/ask spread of $.10. Three scenarios can occur at expiration:

1. The stock stays at or below $50. In this case, the call seller is still obligated to sell the stock to the call buyer. Of course, the call buyer is not going to want to go buy the stock for $50 when it is selling for less. The sold call expires worthless and the call option seller makes his maximum profit of $1.90.
2. The price of the stock is between $50.01 and $51.90 on the last trading day. Remember that the call seller received a $1.90 credit for selling the call option. If the stock is at $51 at expiration, the call seller is obligated to sell it at $50, but the total credit will still make the trade profitable. In this example, the call seller would net $.90 per share. This is usually accomplished when the seller buys back the call option at the lower price.
3. The price of the stock is $51.90 or higher. The call seller will experience a loss. Typically the call seller will buy back the call option at a price higher than the original sale. The seller is obligated to sell the stock at $50 regardless of the market price of the stock. It does not matter whether the stock is $52, $60, or even $100. If assigned, the call seller must purchase 100 contracts at the market price and deliver them to the buyer at $50. This is why selling call options is sometimes referred to as naked calls. You are naked, having no protection if the stock takes off.

These examples demonstrate the rights that buyers have and the obligations that sellers have.  Call buyers and sellers will always have different desires on where they want the price of the stock to go. The buyer of the call option will always want the stock to rise as they have unlimited upside with their option. The call seller will always want the stock to stay below the strike price they sold so they can keep their entire credit.

Introduction to Options – Put Options

Rich Dad Education trainers take their lifelong trading experience and pass it along to students through various educational offerings. This experience helps prepare students to approach the market in a logical and consistent manner. It also helps students identify and take advantage of a variety of market conditions. Identifying bearish conditions and knowing when to enter the market can be a highly profitable endeavor.

Put Options

The buying of put options is a simple and straightforward approach in which a new trader can take advantage of bearish trade setups. Here is a basic overview of put options:

1. You can buy a put: puts are bought on stocks that traders believe will go down in price.
2. Your entry into a trade using puts should be determined by your technical and charting knowledge of the stock.
3. Buying puts does not benefit from time decay.
4. You have theoretically an unlimited reward from buying puts to the point where the stock goes to zero.

Buying Put Trade Setups

 Rich Dad Education students are trained to identify bearish trade setups. They are never forced to rely on guessing or their gut. Traders who simply buy put options because they are sure the market is going down based on their feelings exhibit extreme novice behavior and can be severely punished by the market.

Here are some technical criteria to look for when attempting to identify potential bearish trades.

Strong Areas of Resistance

When you identify strong areas of resistance, you gain solid knowledge of how the stock may potentially behave. Strong areas of resistance often keep the price from going above that price area and can give you valuable knowledge on when you should enter a bearish trade. Traders often attempt to identify a stock in a bearish trend and then enter into the trade via buying a put when the stock hits one of these areas of resistance and then starts to head down again.

Bearish Trends

When buying puts, it is wise to be trading in the direction of the trend. Strong bearish trends enhance the probability of a winning trade. Traders that attempt to buy puts when a stock is going up can have occasional success by identifying short-term halts in the trend; however, this is similar to fish swimming upstream. Traders can simplify their lives and trading by going with the trend as this tends to increase the probability of success.

Overall Market Trend

If the broad markets are in a downtrend then this helps the chances that the stock might get pulled along with the trend. The same logic of swimming upstream applies. Don’t try and be the smartest trader in the world by identifying narrow windows where you can trade against the trend. Simply go with the trend and enjoy the highly profitable results.

Breakouts of Strong Areas of Support

It is a well-known fact in the trading world that stocks fall faster than they rise. Identifying when these fast falling periods may occur can be extremely profitable. When the price of a stock falls through a price area that had previously demonstrated strong support, the results can often be quite dramatic. It is important to learn to identify these areas of support. Once these price areas fail, you need to develop trading rules that help determine when you should enter the trade. The buying of a put can be the trading instrument you use to profit in these scenarios.

These are just a few of the basic, yet fundamental things you should look for in determining whether it is appropriate or not to enter a bearish trade. There are many bearish strategies that can be used to profit from these trade setups and the buying of a put is one of them. The next article in this Rich Dad Education Options Series will cover another of the four option building blocks, the selling of calls.

Degrees of Separation

Source: Wikipedia

“Six degrees of separation is the theory that everyone and everything is six or fewer steps away, by way of introduction, from any other person in the world…”

In the world of relationships, six degrees of separation is an entertaining game revealing how two persons of interest are connected.  It’s an activity requiring a healthy dose of creativity and a detective-like eye for hidden clues.  Often two items appearing unrelated on the surface can be connected after further digging.

In the world of Wall Street investors, curiosity often leads them on a search to find out how two different stocks or asset classes may be linked. This search is really a two part process.  The first step is measuring the extent to which two different assets are correlated which can be done easily using a correlation indicator (recently discussed here).  The second step involves discovering why both assets may be linked which is usually just a byproduct of studying the underlying fundamentals of their individual markets.

Consider the following example using two seemingly unrelated sectors of the stock market – Basic Materials (XLB) and Emerging Markets (EEM).  The Basic Material sector is a basket of stocks in similar industry groups like chemicals, iron & steel, and metal mining.  Emerging Markets consists of a broad group of nations around the world like Brazil, Russia, India, and China.

In seeking the link between both sectors we could construct a logic chain of sorts:

1.  Basic Materials are heavily weighted toward the commodities market.
2. Commodity prices are influenced by investors’ perception that the global economy is healthy – particularly those countries that are big commodity importers or exporters like China and Brazil.
3. China and Brazil are two of the largest countries in the Emerging Markets sector.
4. If China, Brazil, and their fellow brethren in the emerging markets space are strong, then demand for commodities will be strong which, in turn, will drive up commodity related stocks thereby boosting the Basic Material sector.

The positive link between Emerging Markets and Basic Materials can be seen in the following chart:

From top to bottom we have the price chart of EEM, the relative strength of emerging markets (EEM:$SPX – gray area chart) overlaid with the relative strength of basic materials (XLB:$SPX – red line), and finally the price chart of XLB.  Throughout the first seven months of the year both XLB and EEM were underperforming the S&P 500 Index.  Recently, however, both have changed their stripes from market laggards to leaders.  The Basic Material sector’s relative strength turned up in early August (green arrow) followed closely by a reversal in the relative strength of Emerging Markets (black arrow).

As goes one, so goes the other.

Tyler Craig, CMT
Rich Dad Education Elite Training Instructor

Learn more about our Elite Stock Courses here.

Introduction to Options – Call Option Setups

In the previous article in this Rich Dad Education series, call options were discussed. The buying of call options represents one of four core building blocks for all option strategies. While traders who haven’t received financial education might simply buy a call option because they “think the stock will go up,” Rich Dad Education students are trained to identify high probability trade setups. Once a highly bullish trade setup is identified, the call option is one potential trading instrument that can be used to take advantage of this setup.

Buying Call Options Review:

1. You can buy call options – calls are bought on stocks that investors believe will go up in price.
2. Your entry into a trade using calls should be determined by your technical and charting knowledge about the stock.
3. Buying a call is a debit trade – you must pay the premium.

Setups to Identify for Buying Calls

You greatly enhance the probability of a winning trade by identifying certain bullish technical setups before buying a call option. Rich Dad Education students learn technical analysis through elite trainings and the mentoring program. Once a trader has a strong grasp of technical analysis, then their ability to identify and take advantage of high probability bullish trade setups greatly increases.

Here are just a few bullish technical criteria that can help identify potential bullish trades. This knowledge gives a trader a significant edge over someone who simply buys a call option because “they think the price is going to go up.”

Strong Areas of Support

– When you identify strong areas of support, then you have identified a price area that the stock may have difficulty going below. Strong areas of support give the trader highly valuable knowledge of where the short-term floor of the stock may be in order to place bullish trades based on this knowledge. Buying calls in uptrends that bounce off short-term areas of support on high volume is a common short-term trade involving calls.

Bullish Trends

– When buying calls you need to be trading in the direction of the trend. Strong bullish trends enhance the probability of a winning trade. Many novice traders buy calls when stocks are going up in the hope that stock will continue to go up. Traders with knowledge of technical analysis take this one step further by properly identifying that an uptrend is not only occurring but shows strong signs that it will continue to do so. At a minimum, you should not buy calls while a stock is in a downtrend in the hopes that it will reverse course. You should wait until you have technical signals that a reversal is occurring.

Overall Market Trend

– If the broad markets are in an uptrend, then this increases the chance that the stock might get pulled along with the trend. Buying calls at key entry points when a stock and the overall market are in an uptrend greatly puts the odds in your favor.

Breakouts Through Strong Areas of Resistance

– When the price of a stock breaks through a strong area of resistance, this is often a signal that significant upward price movement is about to occur. Oftentimes call options are bought when price breaks through these areas of resistance in order to profit on this price movement. A trader should adhere to their entry rules when such a breakout occurs.

These are just a few factors to look for before buying a call option on a stock. Technical analysis provides the logic to help guide you in making your decision. You may choose to buy call options to take advantage of the trade setups you find. The next article in this Rich Dad Education series will discuss the buying of put options – the instrument that you can use when you see trade setups that signal that the market may be going down.