Dr. Scott Brown Stock Options

Review Let’s review what we know about options. This is very important to reinforce your learning.

Review There are only two types of options: Calls Puts Options are another form of investment that can be bought and sold just like a stock or bond. They are referred to as “derivative” investments because an option’s value is derived from an “underlying” asset.

Why Trade Options? The purpose of buying options is to gain leverage on your investment and to cut down on your initial capital outlay. Options allow you to make a directional bet on an underlying security using a small down payment. Options are more complex than underlying stock and riskier. The reward for the risk are potential lottery sized wins! In simple terms, you’re using options as a substitute for the stock. You have to know how to choose your options correctly to maximize your potential gains.

Option Buyers Have Rights Option Sellers Have Obligations A buyer of a call option has the expectation that the underlying security is going to move up. A call buyer has the right to control a bullish directional long bet of 100 shares of stock for a specified period of time at a certain strike price. The buyer pays a fee to the option seller for this right. The fee is called “premium”.

Option Buyers Have Rights Option Sellers Have Obligations The buyer has no obligation to exercise the option contract if it isn’t profitable to do so. The option buyer has a limited loss potential equal to the price paid for the option, and has an unlimited upside gain potential.

Option Buyers Have Rights Option Sellers Have Obligations The put option buyer has the expectation that the underlying security is going to move lower in price. A put buyer has the right to control a bearish directional position of short 100 shares of stock for a specified period of time at a certain strike price. The put buyer has no obligation to exercise the option contract if it is not profitable to do so.

Option Buyers Have Rights Option Sellers Have Obligations The put option buyer has a limited loss potential equal to the price paid for the option, but also has an unlimited upside gain potential. When you buy a put option, you’re giving yourself the opportunity to sell something at a certain price for a specified period of time If you own a stock and you are willing to sell it, you can buy a put option contract, which allows you to pick the price level at which you may want to sell the stock and the expiration date.

Option Buyers Have Rights Option Sellers Have Obligations The seller of a call option has a neutral to bearish view of the underlying security and has an obligation to fulfill the terms of the contract if the option buyer decides to exercise the option contract. The seller of a put option has a neutral to bullish view of the underlying security and has an obligation to fulfill the terms of the contract if the option buyer decides to exercise the option contract.

Probability is the Key Option trading is based on probability and statistics. As smart option sellers, we want to be the ones who take the other side of low-probability loser trades and turn them into high-probability winner trades for us. Selling options can be profitable when the potential for a high probability of success is used correctly.

Probability is the Key This is the option market, a place where you get to control something large for a small amount of money. An option’s value is derived from another asset; hence, options are considered derivative investments. There’s a certain way to buy options correctly which is: Deep-in-the-money (DITM)

An Option Example We’re bullish on Intel stock (INTC) trading at $21. Think of the out-of-the money $25 strike price and 162 day expiration (five-month option). This option trades for a premium of $0.40 per option contract. Option prices have a $100 multiplier so our call cost is $40 ($0.40 x 100). We get to control 100 shares of INTC for the next five months at a cost to us of only $40.

An Option Example To find our cost-basis or breakeven price, we add our cost (option premium) to the strike price: $ $25 = $25.40 If the option is held to expiration, we won’t make money on the position unless INTC rises above $ If you plan to trade out of the position below $25.40 before expiration, then you may see a profit, depending on how fast and how far INTC moves higher.

An Option Example The advantage of buying options instead of the stock is the leverage you get. You spend a little money up front to control the 100 shares. Instead of paying $2,100 to buy 100 shares of INTC, we pay $40 today using options. If INTC gets above our breakeven price of $25.40, we have a decision to make: 1. Sell the option back to the marketplace and pocket our gains. 2. Exercise the option and turn it into actual stock shares.

An Option Example If we decide to exercise, then we must pay the full stock purchase price. In this case, we’d have to come up with the extra $2,500 to pay for the 100 shares of stock we exercised.

The Profit/Loss Scenario The profit/loss (P/L) chart plots our position with the stock price on the bottom and our potential dollar gain / loss on the left side. The Call cost us $40, that is the maximum we can ever lose as indicated by the horizontal line that stretches from $0 to $25. As mentioned earlier, when you buy options you have limited risk, $40 in our example.

The Profit/Loss Scenario The line starts to bend upward at our strike price of $25 and crosses the $0 P/L line at $25.40 (breakeven price). Once INTC gets above $25.40, we’re making money for as long as INTC heads higher. Our profit goes up as the price of the stock increases. When you buy the INTC $25 call option, you’re really holding something that has no value. It becomes valuable only when INTC goes above $25.40

The Profit/Loss Scenario

The problem is that many investors tend to pick strike prices too far away from the current price of the stock and/ or an expiration period that’d too close in time. These investors think that they can predict the very short-term moves with pinpoint accuracy in the short time allotted.

The Profit/Loss Scenario When you buy a put option, you’re betting on the price of the stock to go down. Your risk is limited to what you pay for the option and your reward is limited to the premium you pay for the option which is ALWAYS less than buying shares of stock. In this case, the chart looks reverse. This is because your profit goes up when the stock goes down. In this example of a put option purchase, the stock was at $38 and we bought a $35 put option. The horizontal part of the thick line represents the maximum we can ever lose, $35. No matter how high this stock may trade, we can never lose more than $35. On the upside, our profit is unlimited. We can make as much money as possible to the point of the stock falling to $0 per share.

The Profit/Loss Scenario

Stock Price & Strike Price Relationship For call options, if the strike is higher than the current price of the stock, it is called out-of-the-money (OTM). This is abbreviated as OTM for ease of reading. Any strike that is priced near the current price of the stock is called at-the-money (ATM). This is abbreviated as ATM. Call strikes that are below the current price of the stock are in-the-money (ITM). This is abbreviated as ITM.

Stock Price & Strike Price Relationship Put options are the opposite. Any put option whose strike is lower than the current price of the stock is considered on-the-money (OTM). Any strike price that is priced near the current price of the stock is considered at-the-money (ATM). Any put option strike price that is higher than the current price of the security is considered in-the- money (ITM).

Disclaimer DISCLAIMER: THE DATA CONTAINED HEREIN IS BELIEVED TO BE RELIABLE BUT CANNOT BE GUARANTEED AS TO RELIABILITY, ACCURACY, OR COMPLETENESS; AND, AS SUCH ARE SUBJECT TO CHANGE WITHOUT NOTICE. WE WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM RELIANCE ON THIS DATA OR THE OPINIONS EXPRESSED HERE IN. DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES, FOREX AND OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS SHOULD BE USED. FUTURES, FOREX AND OPTIONS MAY NOT BE SUITABLE INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THAT THE EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES OR FOREX POSITION.HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. PS. In our opinion, we believe, it may be possible, that heavy smoking and drinking may be hazardous to your health. If you choose to smoke and drink while trading, The Delano Max Wealth Institute nor Dr. Scott Brown is liable for any damage it may cause. If you slip and fall on the ice, we're not liable for that either.