Income On Demand

income on

demand
Masterclass Sessions
#2: H
 ow Options Work

By Greg Robinson
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Introduction

Hi, Greg Robinson here, again, Editor of Agora Financial UKs Income on
Demand options trading newsletter. I hope you enjoyed our first guide and
found it useful.

Now, remember, the simple idea here is to reveal how you could use
options to regularly pocket extra income.

In the first part of this special series I walked you through how selling put
options work.

As I said then, Im confident this strategy will change the way you view
investing forever.

It certainly did that for me.

Now, in this guide, were going to dig a little deeper into how put options work.

First, Ill show you some of the language we use in the options markets and after you understand
some of the basic lingo of options Ill walk you through a trade.

The language of options

Lets start with the terms I regularly use in Income on Demand, the first of which is option contracts.

This is simply an agreement to buy or sell a stock at a certain price in the future.

The buyer of the option has rights while the seller of the option has obligations.

Second, the option always has an expiration date.

For most options the expiration date is the third Friday of the month.

When it comes to selling a put expiration, two things could happen...

If the share price is below the strike price, it will be exercised, in which case you, the option seller,
buy the shares.

If the share price is at or above the strike itll be left to lapse, in which case you do nothing.

The third term is the strike price.

This is the agreed upon price at which an option buyer can exercise their option. The price is based
on the underlying security, which in our case is simply the share, on which the option being traded.

Put option buyers have the right to sell the underlying shares at the strike price.

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The put option seller, also called the writer, is obligated to buy the shares at the strike price, if the
buyer exercises their options.

Say you want to sell a $20 put on company ABC, then $20 is the strike price.

A fourth term is premium.

Were almost acting like an insurance company here. Were taking money and if the driver doesnt
get into an accident we keep the money.

As the insurance company we simply keep the money they pay for the insurance. In options lingo
that money is called the premium just like it is in the insurance business.

Okay, now for our fifth term...

The stock on which the option is written is called the underlying security.

If two traders are talking about trading options on Corning, as we looked at before, then Corning is
the underlying security.

In my Income on Demand guide for trading options I go over these and other terms that will help
your education along.

Once again, the terms are, option contract, expiration date, strike price, premium and
underlying security.

Now, lets walk through trade so you can see how the language youve just learned is put into practice.

The language in action

In our last guide I likened a put trade to making a lower offer on a house, and I compared it with a
trade someone could make on a good American manufacturing company such as Corning.

Now, I want to walk you through another trade.

The example were going to look at is Texas Instruments.

If youve never heard of them the company is primarily a semiconductor manufacturer.

Readers of a certain age will remember some of the early electronic calculators they produced and
also the Speak and Spell educational toy that was used in ET.

Nowadays, they are one of the top ten semiconductor companies in the world. They focus on
developing analogue semiconductors, which are used to convert real-world analogue signals such as
sound, temperature and pressure into digital data.

Lets say for example that we became interested in Texas Instruments back in August. We ran
detailed analysis against the company and they passed the assessment.

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We know its a large company with a huge market account and the research shows its very healthy
and its forecast to keep growing in the future.

Texas Instruments is exactly the sort of stock youd be happy to hold long-term.

In our example of 22nd August we decided to enter the market with a put order that would allow
us to buy Texas Instruments for even less than its trading for that day.

After careful analysis we chose the price as $70, which is 23c less than it was trading at the time. Its
like were saying to investors Im here for you if you want to sell me your stock at a discount.

Heres the trade well do for this example...

The trade
We sell to open one Texas Instruments September 2016 Put, with a strike price of $70 for a
premium of $1.10.

What exactly does that mean?

Well, remember, the put option obligates us to buy Texas instruments at $70 a share, if the stock
falls to less than that by the expiration date, which in this trade is a month ahead.

Technically, the buyer, who paid $1.10 for the right to sell us the stock has to exercise the option for
this to happen, but if the price of Texas Instruments is below $70, most brokers will automatically
exercise the option anyway.

Heres what we get from the deal - selling these puts gives us $110 per option contract. So, if we
kept it simple, and sold one option contract, we get a total of $110.

And heres the thing I love about selling put options...

If the stock prices remain unchanged and Texas Instruments had been $70, or above, come expiry,
our obligation is simply removed and we would keep the $110 premium.

Then we can go and do it again on the October, or November contract, and so on, and so on.

Do that repeatedly over the year and you can see how it all adds up.

What if the share price falls?

Of course, theres a chance were selling put options and a stock will sometimes be put to you and
youll have to buy it.

Thats now exactly what happened in this case.

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The share price for Texas Instruments fell down to $69.36 on 16th September 2016. In this case
well keep $110, but were obligated to buy the Texas Instruments stock at $70 a share.

Wait a minute...

That means were paying $70 for a share thats trading for $69.36.

That does not sound like a great deal.

True, we are paying more for the share than its currently worth, but also remember we received
$110 in premiums when we sold the puts.

That means our effective share price, per share, is only $68.90.

Heres how we work that out...

You purchase 100 shares of Texas instruments at $70 for $7,000. Then we take away from that the
initial income we gained from selling the put premium $110.

So, for 100 shares that wouldve cost you $6,936 to buy, you only paid $6,890. Now youre a
shareholder, just like everyone else, only you got in at a discount.

Plus, if you hold the shares for long enough youll also get the dividend going forward.

In fact, in this example, if we constantly held the shares until November, we would have picked up
a dividend of $50 as well. Thats $50 on top of the premium we received for writing the options.

One way to think about it is that youve received $160. Thats $110 in option premiums, plus $50
in dividends.

Now, of course, there is always the risk that the stock falls dramatically and even the premium we
collect from the put wont cover the initial loss. You need to be aware of that if you choose to follow
an options trading strategy.

But now, we can move on to the second part of the strategy, selling covered calls. That allows us to
even more income from the stocks we buy. Ill briefly walk you through that scenario now...

Selling covered calls

In the example of Texas instruments the price did drop below $70 and we were obliged to buy
the shares.

Remember, its fine if that happens, because were happy to own them.

In this scenario weve bought a solid company at a discount and we can also earn the dividends.

You now own 100 Texas Instrument shares that you essentially bought for $68.90 each.

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Just as there are investors who think the share price is going down, there will always be others who
think the price could be about to go up. Thats how you get a market.

One way investors can take part in this market is of course by buying the shares, but another way is
by buying call options.

Now, what were going to do is sell these investors the call options. For doing so were going to earn
even more premiums.

So, imagine youre approached by another investor who thinks Texas Instruments will stage a big
rally in the next few months, which could take the shares higher.

He says to you:

I believe Texas Instruments shares are going to shoot up in the next month and Id love the
chance to buy them from you for $71 each. If Im right thats going to be cheap and Ill pay you
$105 for the rights.

In this example the other investor would pay you upfront cash if you agreed to sell him your Texas
Instruments shares at $71 each.

Again, this agreed price is called the strike price.

The $71 prize you would sell your shares for would allow you to make a profit on the shares.

Should you do this?

Well, lets consider the two likely outcomes...

The outcome
Outcome one: Texas Instruments trades for more than $71 when the contract expires. You would
then sell your shares for $71, which is a nice gain in pocket $105.

Outcome two: Texas Instruments doesnt trade up to $71 before expiring. The other investor, the
buyer of your covered call, will not exercise his rights to buy your shares since he can get them
cheaper on the open market. In that case the contract expires worthless, but you keep $105 he paid
you upfront.

For the purposes of our example lets say that when it comes to expiry Texas Instruments was
trading at $69.95.

You wouldve kept the shares and pocketed the $105 premium.

And heres the best bit - you couldve sold another covered call, right after, to collect even
more income.

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In this case the following month we wouldve sold another covered call with the same $71 strike
price. This time picking up a premium of $170.

When it came to expiry the share price had risen to $72.60, so our call was exercised. This meant
that we sold our 100 Texas Instruments shares for $7,100 and kept that second premium.

Lets look exactly whats happened here...

Firstly, we sold the put and collected $110 in income. The put was exercised and we were obligated
to buy 100 shares of Texas Instruments. A stock were very happy to own. Then we sold a covered
call and collected another $105 in income. This was not exercised so we kept the shares.

Then we sold another covered call and collected another $170 in income. That call was
exercised, which meant that were obligated to sell our shares at $71, meaning we made $100
on the shares themselves.

So, with an exposure of never more than $7,000 for shares we wanting to own in the first place, we
collected $485 in cash.

Plus, because we held the shares during the dividend payments, we bank an extra $50 there to.

In just three months we made $535.

Thats 7.6% return on your investments in just three short months.

Thats how selling covered calls the Income on Demand way works.

When youve used covered calls the right way, these sorts of returns are possible on a regular basis.

The great part is you dont have to go out looking for investors to take the other sides of these
trades. The options market is full of them and theyre always willing to pay you money.

Next time...
To sum up for today weve delved deeper into put selling and have just explained the basics of
covered calls.

It boils down to buying a valuable asset and then collecting instant cash for selling someone the
right to buy that asset.

I hope youve seen in these examples how you can make extra money and extra returns on relatively
stable stocks.

Using options allows us to potentially make a consistent income, while reducing the cost of owning
the shares you might want to own.

The important thing is remembering some of the terminology, which is not that difficult.

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Now, in the third part of this series Ill show you exactly what type of account youll need to own to
get started.

Look out for it.

Best wishes,

Greg Robinson
Editor
Income on Demand

The information in this guide is general information only. It should not be considered as investment
advice. Published by Agora Financial UK Ltd.

Option trading is high risk and may not be suitable. Ensure you fully understand the risks involved and
never risk more than you can safely afford to lose. Seek independent financial advice if you are unsure of
the suitability of any investment.

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House, 2nd Floor, 56-58 Southwark Street, London SE1 1UN. Agora Financial UK Ltd is authorised and
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2017 Agora Financial UK Ltd

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