THE 4 PILLARS OF INVESTING Cash Flow: Module 3 TRANSCRIPTION

Transcription

1 THE 4 PILLARS OF INVESTING Cash Flow: Module 3 TRANSCRIPTION

2 2 The 4 Pillars of Investing A transcription of CASH FLOW MODULE In fact, brokers what s interesting, I was teaching in California actually and I was teaching a live class and a lot of brokers come all the time. That broker came up to me and said and he said, Andy, the though thing is I can t really make a lot of recommendations to people because they re not educated. I mean, do I want the liability of...? And he s so right. Do I want someone who s close to retirement come in and want the trade options and stuff? Not if they re not educated. It s a tough deal. What happens so often, and I think a lot of brokers would freely admit to this, is we get what s called broiler-plate investing. We go and we say, Okay. Here s my age, here s my income, here s my transfer risk, yadi ya ya Then, they give us a broiler-plate and just say, Okay. Here s you re investments, here s your flight. Good luck. What happens is you get to a crossroads which many millions of people that are at it right now where you have a crossroads, where you got a choice between A and B and here s your choice: A. is you could tell your goals to fit in strategy that you re in now which usually means you sit down with them and you say, Okay. Well, we re going to have to work a little longer while you re in the office. We re going to live cheaper and save more money and we re going to live less as an inheritance to our children. So what they do is they take the big goals and the fun goals, and a country club, and the world traveling, the beach house, and all the stuff that you and I would really like to dare dream about and they just take it away and they say, Look, she s not realistic. All these mutual funds are the only likely to perform as well and they might not even perform. They might wind up down like this. It s rough because they could tell strategy. Okay. Choice B is education. You re saying, No. I want to have this life I dreamed of. I only live one time, and I don t even have opportunity two, or three, or four lives then unless you come back as an ant or something and then you might get stepped on.

3 3 So, as a human being, you get one shot at this thing. We want to learn strategies maybe fit our goals. Well, the problem with that is if we want goals or strategies that provide us more income faster, we will be usually using some type of leverage and that means more risk management. That means more active involvement. I, for one, like Choice B simply because I don t want to let go of that stuff. I like the idea of having a cool lifestyle. I like the life I have right now and I don t want to give it up. I have to learn and improve on it. So, working on and you re living cheaper, you re living less to the family is not an option that I like. I d rather say, Okay. If I need to be more aggressive and we re going to talk about leverage now, okay? But a lot of people are running out of time, getting close to being empty and they d got to choose which road they want, and I like the road of education. It s just my personal preference and I think you re probably the same. So let s say I want to go to Hawaii and that s my goal. How will I get there? Well, here s the thing, you got to choose a vehicle. In going back to this, if you ride a bicycle, then you ve got to live with what a bicycle can give you or you got an upgrade to a better vehicle. Choice A; Well, looking at this bicycle we ve got set up in the riding, this is the radius of which you can travel. Okay. Well, I wanted spatial. That s more risk. Spatial is more complex than bikes, right? So that s kind of the analogy I want to make here with as you choose your cash flow, and that s our topic is cash flow, see, you also need to choose not just buying and selling; you need to choose what type of leverage you want or don t want and what type of vehicle you get. So, if you choose B saying, Okay. I need a car or a truck or a plane to get me here, that s the big deal. So it s a really great analogy. Let s say want to walk to Hawaii. Well, are you going over here and you re going to walk to the water s edge maybe in San Diego? That s a nice place to take off. Maybe you swim out of the bay in San Francisco. Now, you re going to have to swim a long way and walk a long way, but probably not the best way to get there, right? Certainly, not a lot of people get here walking. You just can t walk very far, okay? We ride a bicycle. Now you can bike across the country. It takes a while, but Lance Armstrong from Austin right here could do it, but he d have to pick up a lot of speed by the time he hit the water. If you hit that beach, you better be moving if you want to go to Hawaii. Not the best vehicle. There s probably less people killed here than maybe in a car. Even then, you re going to give lot of speed. In fact, you know what, the best vehicle I think on the board is the plane, but it s the most complex vehicle of all of these, right? This guy flying this thing, it looks like he s having a good

4 4 time and he s making it look easy. But you know what, he s been trained. For him, a pilot, it is easy for a pilot. It s just not easy to fly a plane for you and I. We have to go to flight school and which brings us to risk. It s a very important part of your cash flows strategy because whatever cash flow strategy you choose, you re going to have to learn what the risk is and how to deal with that risk. Now, it s interesting because most people, I bet you re more likely to get hit by a car, fall off your bike, or die at a car wreck down here. I bet per travel, this is probably the safest. I don t know but I know it s safe for the car travel, but is probably the safest. I understand a couple of questions we need to ask you. First, what vehicle do you want to use? What cash flow vehicle do you want to use? You got your look, you got your fundamentals. We call that fundamentals and FA, Fundamental Analysis. Then, you got your technicals, right? You get technical analysis and that is where you re at, okay? Now, how do you get a harvest? What vehicle you want to fly on this when the harvest did? You want to go on this when the harvest did. That s why we re talking about it. One of things I don t like about market is they tend to do this. Let s draw this graph here. What they ll do is they ll pitch this and say, Okay. Here s your risk. Okay? R-I-S-K. Here s risk. Then, they ll say, Here s reward down here, so we ll abbreviate. So we have to live painfully through my inability that we will painfully take that on. So, here s our reward. What they re saying is is that it looks maybe to be something like this that the more reward you re seeking, the more risk you have to take. That s generally because they re just looking in a vehicle, but that doesn t answer the second question which is, who s driving? If you take the average person and you put them in this plane, they re going to crash. In fact, when you look at the guy who s got the most leverage, he s also got the most education. Now they say planes are safe than the cars. I don t believe that. This thing s a million pounds 747. It s one million pounds. It s flying at 40,000 feet in the air. It s going 600, 500 miles an hour. There s a lot of bad things that can happen to something that weighs a million pounds 40,000 feet in the air. The atmosphere is different. It s like the Iron Man. You have to solve the arising problem. All this type of stuff goes on. So, this thing blows entirely and rolled to a stop. So I think on of the things that people do is they make a mistake here. They say, Well, I don t want to do anything aggressive. I don t want anything that can really get me where I want to go fast just because I ve heard that it s aggressive. Remember that on this risk reward thing, I ve heard that if I want a lot of reward, I have to take a lot of risk.

5 5 I don t want to do that. So I ll take less reward and I ll be in the vehicle that has less risk. Well, that s fine, but you ve go to ask who s driving this car? In my opinion, is a BMW a safe car? That s on who s driving. Put a drank teenager behind the wheel. So my Robert Mcken (ph) and I, we talked about this a lot. We think people are more risky than vehicles. I d rather be in this plane with someone who really knows what he is doing than in this car with someone who doesn t know what he s doing. So, I think points were all taken. It s who s driving. When you have someone that goes through the education continuum and who has awareness, confidence becomes proficient, I think that reduces risk. The greatest thing you could do to reduce your risk, I think, is get educated. I really believe that s true. So, let s look at the continuum here and do some math. It s very, very easy. Here s how we calculate the rate-of-return we want. Now, why am I talking about this? Well, let s go back here. If we want to do this, we re playing a little catch up here. This is all about rate-of-return. What percent are you getting? Maybe over here, you re getting two percent. It looks like that s what s going to be likely or maybe five percent. Well, five percent, that s what you will get. That s what will happen. So maybe over here you go for higher percent, so this is what you ll get. So it s all about your rate-of-return. If that s true, we need to know how to calculate this rate of return. Oh, there is a method the way he s doing here. I see. So here is our formula for rate-of-return. It s actually very easy to do. They call this arithmetic return. Another way you might have seen this written is Vfinal, the final value of the investment, minus the initial value of your investment, divided by the initial which is essentially the same thing that we have right here. So, very simple. Very simple. You could do this if you d like. So here I have my final investment. Maybe I bought a stock at hundred and I sell the stock here at 110. So I take 110 minus 100, it would be what? I think that would be 10, right? I divide it by 100 and that gives me 0.1 or 10 percent. Very simple. Well, there s a couple of different ways you can increase your rate-of-return. Number one is, you could find something that grows bigger, okay? A big gain. In other words, the stock goes from 100 to 200. And guess what? That doesn t happen much. You ll be sadly disappointed if you try to double your money every time. It just doesn t happen. So the first way is to find huge gains and you re getting small cap hoping they go big and get huge gains, okay? There s another way you can go about it, though. Another way you could go on about

6 6 it is, you can reduce this initial investment number. The closer this number I learned this in calculus, and I really don t know calculus. I probably shouldn t bring it up. But I wasn t a very smart kid but my coach made me it. I had to take it three times before I passed it, so I got stuck at it. But if we take the limit, and you guys are big calculus fans. You can act smart, right? I just don t. We take the limit as the initial approach is zero, there s a positive number here, it might look better, then the closest that gets to zero, this goes to infinity. So one other ways we can do it again, I want to just review it quickly, is we can try to find investments that will start $ 100 and it just goes through the roof over 100,000 which just doesn t happen very much. Where do you find the opportunities that that happen? They just don t happen. But what if we can find an investment that goes from $110, whether the investment is $100 or $110, but we don t have to put in $100 bucks but, yes, we still got the 10 and that would increase our rate-of-return. Who gets an infinite return? People criticized me saying that there s no such thing as an infinite return. Oh, yes, there is. Let me show you one. How about your 401K? Your 401K has an infinite return. What? Yes, it does for the people that sell it to you. There he is. There is broker guy. Now let me tell you about broker guy, talking with a smile his face, let s just turn him right into the Jack-in-the-Box and got it right now, okay, because this guy, given in Jack-in-the-Box, he s a pretty happy camper here. Well, ask this: How much money do they put in zero? Let s say it with zero in the investment but they take $100 in feast. Even if years goes down, what was their initial investment? Zero. So if you take the $100 they made of you and they didn t put any skin in the gain, they took no risk. By that one zero, you get an infinity. Try it in a calculator. You ll get one of two things. You either get an E or an infinity depending on your calculators. So that creates a continuum where we have lots of money and no money. There are investments that you d learn about that exist all way across this continuum. In other words, we do fundamental analysis, FA, and then we do our technical analysis, TA, and we say we think the stock is going up. How do we exploit it? Well, we could put a lot of money in and buy the stock or we could do things that don t even require any money and still get a gain of it. It s just that your risk will be higher down here. Very interesting stuff. It s called leverage. What we re going to do now is talk about investments that are going up and down but we re going to do one thing. Whether we re going to go along by the stock or we re going to buy an option and see what the difference is. I think you will enjoy discussion immensely. I know I do.

7 7 Now, the reason I like leverage and I like to speak about it is it s a way for people to get places faster. When we speak about leverage, we usually hear people say, Oh, my gosh, it s highly leverage. Well, that means he s in debt. We re not going to the debt in this particular instance. Well what s cool is this: we re going to do our fundamental analysis, we re going to do our technical analysis. We re just going find a place along this line. So let s talk about options for a minute because that s a form of leverage. So an option is another alternative to making money when stocks go up. You do your fundamental analysis, you do your technical analysis, and you say, Okay. I think this stock is going up. Well, you could either buy the stock or you could buy the option. What is going to determine whether you buy the stock or whether you buy the options? Well, one is going to be your goals. Do you want more money faster? If you do, they ll need to manage additional risk and part of that is learning what an option is. So let s talk about what an option is. An option is simply contract. It s an agreement. It s a handshake. It s an agreement between two parties, and they re both different. Both parties were different. The first guy in the option is going to make a promise to you and the second guy, which would be us in this case, has a choice. Another word for choice, hence the name, it s an option, okay? I think, to illustrate how this agreements work is I m going to an example that s very silly. It s cartoons, right? But I think it helps people understand it much better than using stock at first, kind of like to do with the cell phone. Silly story but it helps to make a point before we get clouded in stock. So here we go. Let s say that this guy over here that s well-dressed well, of course he s well-dressed. He s a tailor and he s got a tailor shop. We see behind him in the shop, there s a tuxedo that s looking pretty nice, a thousand dollar suit there. You are interested in that suit. It s on sale for $1,000. Now, you can just whip out a thousand bucks, boom, hand him cash and buy the suit if you want, especially if you think the suit would grow in value. Maybe you ll sell it to someone else for $2,000 someday, but first we got to get to buy it and we think the suit is going up. So once we think the suit is going up in value, we got to decide how we re going to harvest this information. How are we going to harvest our fundamental and technical analysis? Well, one of the things that we could do is we could say, I want to buy the suit. Another thing we could be able to do instead of buying the suit is put it on lay-away. Now if you re from the United States where I m from, you probably understand the term lay away, but if you re outside of United States, often the case here you and I are speaking across the

8 8 ocean and I will teach this in the great, great UK, the United Kingdom, from time to time across if I m in there. I remember I was in the UK once and I said, Lay away, and the lady said, Lay away which? Lay away? We don t know what that means. See, I don t really have a good British accent. That s terrible. She said, I don t know what that means. Please make that clear, sir. I said, Okay. Lay away is like this. It s when you asked the merchant to hold that suit for a couple of days at that price while you go home and decide whether or not you want it. She said, Oh. You mean want to put it on reserve. Well, whatever. Lay away or reserve. So let s say we do this. Let s say we strike a deal here and he says he writes down on the business card. He writes suit on his business card $1,000 and he gives it to this guy. They shake hands and now they strike, that s the important word, strike a deal at a thousand bucks. So what that means is now this guy can come back to the tailor shop and he can buy the suit even if now it s worth $2,000 or $3,000. See, it s one sale. It s not everybody else s sale for here. That s not how sales work. So maybe it goes up to $2,000 or 3,000 later, but this guy now has a contract. He has an agreement. He doesn t have to buy it. Remember, it s not an obligation. It s a what? It s a choice. But this guy does have an obligation. He has made a promise to sell this to him at $1,000. So you see the option here? The reason they call it an option is this guy still has his options open. He can buy the suit or he cannot buy the suit, but he s got the price locked in forever at $1,000. If he comes back the next day and this thing is 2K, he gets to buy it for $1,000. Why? This guy made a promise and maybe it goes even higher. Maybe you re watching the SP Awards. Well, you know how everyone wants to be like Mike. When he shoot and he drinks Gatorade, I want it. He s got the Hanes shirt. I want the Hanes shirt, right? He s eating at McDonalds. I want to eat at McDonalds. Everything the guy does everyone else wants to do. So, Michael Jordon goes the SPs and he puts on that tuxedo, same what you have now and everybody wants it. It s the Michael Jordan Special. He s got the SP. He s got the basketball. Michael Jordan Special, $5,000 that thing s worth now. But guess what, this guy made you a promise and his word is his bond. He made you a promise to sell to you for how much? Thousand bucks even though it s worth 5,000 bucks. Then you say within your mind, Wow. That means I can buy it for $1,000 and sell it

9 9 for $5,000 somewhere else, maybe the Michael Jordan fan club? Man, that thick bundle piece of paper now can make me $4,000. So that s called intrinsic value. In other words, the fact that he can buy suit cheap and then sell the suit expensive somewhere else he can buy it for $1,000 and he could sell it for 5,000 now, that means that little piece of paper can make him four grand. That s pretty cool stuff. So, and this is the best part. Is he going to back to buy the suit for $1,000 and then try to deal it for 5,000? No way. Where s the power? The power is not in the suit right now. The power is where? It s in his option contract. This $4,000 of value is coming from his ability to buy it cheap, right? He has the ability to buy something that s worth five grand for only one grand. It s like having a coupon for four grand, isn t it? It s no difference. It s been like having a coupon for four grand. That s what its worth. So it goes that the Michael Jordan fan club, there s the president loving 23 Michael Jordan, that s his number. He says, I love Michael Jordan. I ll give you money I ll give you four grand for the contact. Why four grand? Because that s what its worth. The suit is worth five grand. So 1,000 for the contract, right? A thousand? Well, you got a pay me for it. So this guy gives you four grand and he gets the contract of suit. You never really have to talk to the tailor again. Why? Because you sold your contract. One more time, to make sure you got it right, puts the suit on layaway. He strikes to deal with $1,000. The value of the suit goes up. You have the choice. He s made your promise. Now the thing s worth four grand as the suit went up. Now look at this. This guy who buy that contract paid cash. This is the most important part. See how that contract gets turned into cash? Let s do it a bunch of times. That contract gets turned into cash. That s the secret. So again, we want to make sure you have this right. You make the guy makes you a promise. You have the choice to buy a suit at 1,000 bucks. It s your choice he s promised you. The suit goes up in value, hence your contract goes up in value with the difference between the two. Now people will buy that from you and turned it into cash. That s the important part. You have something that became valuable and you turned it into cash. You don t really have to come up with a thousand bucks. So, if we re going to continue on, we did the fundamentals and technicals and we say the suit s going up, we could have done a couple of things here for better leverage. The closer you get to zero, the closer you are to infinity. You could have just bought the suit right there on first day. Here s a thousand bucks. Then, sold the guy the suit for five grand and that made your 4,000 that way. You can t sneeze at that. It s

10 10 40% return. But that s not what you did. You put on a lay away for absolutely no money. Now remember this formula, right? Remember this formula. So, you sell the agreement for four grand. You profit four grand. So think about this. This option s final value is four grand. That s what you sold it for and it cost you zero money to get it, right. Zero money to get it. He just gave it to you. So you divide that by zero which is undefined, which means you have a return as what? Infinite return, baby. That s awesome stuff. So have no fear. We have all type of investments that range from spending a lot of money on stuff all the way down that they can control some stuff with no money. We have another one. You could have use debt and stand here with no money. Borrow a thousand bucks, pay for it, sell it for five, pay back your 1,000 and you d be left with what? Four. That would be debt. That d be infinite return. So there s a lot of different ways to skin a cat. If you didn t get it, just go back over it again, right? You can do it. The guy makes a promise. You have a choice. Thing goes up in value. Your contract is now worth more, so you simply sell the contract to cash. Very simple. So that s how stocks and options work, right? That s how stocks and options work. Now, let s talk about the real stock and option. Here is an example. Let s say the stock is at $50 today. So that s where it is right now, and you did your fundamental analysis, right, FA? You did your technical analysis, TA, and you ve determined and you think this is going up. Okay. How are you going to harvest this information, okay? You think it s going up. How are you going to harvest that? How are you going to make money on that? Well, the first thing you could do is you could buy stock over here, right? That means you re going to own shares of the company. You re going to be what we called long the stock, right? Long the stock. So, you buy a hundred shares of 50 bucks. That means you can lose five grand if you have no exit strategy, but I know that you will have an exit strategy, right? So, you can lose five grand but you won t because you re going to have exit. Stock does what you want it to with head on up here. It goes up. Now, it s worth a hundred bucks, you can sell a hundred. Now, you turned your 5,000 into ten. So, your reward was $5,000 and your risk was $5,000, and the return was like 100% on that. A hundred percent return. So let s call it one bag of congratulations. Over here though, another thing you could do is instead just buy the option. An option on a $50-stock like this, maybe about three bucks is all. So, maybe about $3. You re going to have to buy have 300 of them, though. That s for your leverage counts. It s a hundred of shares per contract.

11 11 If you buy eggs, they come 12 do a dozen. Why? Because that s how they re packaged. Can you imagine this going to the check-out line you d be, One egg, please. That s not going to work. So, they come packaged. Options, the choice price, you got it for hundred shares on the lay-away at that time. So, that s not too hard to understand. So, if you buy one option and one share to put on a lay-away, it costs you three bucks. See, they don t just put on the lay-away. You go to the market and maybe say, Hey I don t want to spend this kind of money on it. I just want you to put it on hold for me, right? I want you to put it on hold. I want you to put it on lay-away at this price. I want you to do it for two months. So, if you want to ask for two months of time setting it aside, they re going to charge you for that. It s not going to be zero but they re not going to charge you 50 bucks. They re only going to charge you three. So, three times the hundred shares in the contract, that s where we get that 300 bucks at risk. Now, the reason, this is very important, as people get worried, they say, Weren t options risky? Well, one of the things you have to know if you do an option is you have to know how much you can lose, and the most you can lose over here is five grand if the company goes bankrupt. The most you can lose over here is 300. Maximum risk is what is called premium paid, and the premium is simply a fancy word for how much you spent on an option. I know a lot of new vocabulary. That s why I give you access to it more than once. Do you know how many times I have through this before it sunk in? Like a thousand times, but we make it simple so you won t take a thousand, maybe a nine hundred, not a thousand. So, here we go, you got one option, $3, 300 bucks at risk. That s the maximum you could lose. Now the price goes to a hundred but guess what? You have a choice. You have a choice where you can buy it at $50 because that s where you locked it in that. Well, if you could buy it at $50 and sell it at a hundred today where it s at, that s worth 50 bucks a share. You ve done this on a hundred shares, that s 5 grand. So, you take $5,000, subtract the 3 you put in, your reward was $4700 and $300 risk. This, in case you didn t notice, there s a lot higher percent return than this one is over here is good as this. So, all that I want you to learn right now is, look, it doesn t really matter if you understand premium yet. It doesn t really matter if you understand an option perfectly yet. What you do need to understand is that when you do a fundamental analysis and you do technical analysis, you re going to have the stock opinion and you can harvest it with a stock and make some good money or you can harvest an option and make some great with less in the gain.

12 12 So, why are these more risky than others? Because options expire, right? Now let s look at the comparison here. So here, we did our fundamentals, we do our technicals, we got the bias that we felt the stock was going upwards, and we had two choices. Choice number one: Buy the stock. Buy the five grand, sell it at ten, profit five grand, 100% return, double your money. Or you buy the option. What s another word for option? Choice. In other words, you didn t buy the stock; you bought the choice to buy the stock. At what price? Fifty dollars. So, you have the option to buy this at $50 anytime between now and expiration. Well, when that stock went up to a hundred, you still have the right to buy at 50, and you re able to do this on a hundred shares. So, that means that agreement, since you could buy at 50 if you could buy at 50 and sell it a hundred, that means you can make $50. In a hundred shares, you have two zeros. That s 5,000 bucks. That s what that agreement is worth. So, you sell the agreement. From there, your profit: 300 in, 5,000 out, 4,700 bucks. If I was the ring, then I can do it perfect in my head, but that s like 1566% return or something like that. So, in front of this return. We ll keep going over it. Leverage. Why they are risky? They expire. See, you buy the stock and it goes down, you still own the stock. You re down 10%. You re down 20%. Hey, baby you don t get that thing going where it needs to go. By the time it expires, it s worthless, right? You don t have the right to buy it after it expires. So, that s why these are often considered more risky, at least, one of the reasons is that they can expire, right? They have that expiration date on them. Here s an example of what they look like. This is called an option chain, okay? See this right here? Option chain. I should put that in blue because that matches, too. Well, we should put that in red, then we can see it. It is called an option chain. The way it works is this. Let s just look at this. It looks complex but it s really not. Right here, we re going to see the expiration. It s for October. So, these option contracts will expire on October Now, we see all kinds of numbers here. On this side are call options. That s what we re going to work on for right now, and these are the call options. Down in the middle, I see different prices I can put on lay-away. So for example, this is Microsoft and the last trade that we made on Microsoft it looks like it was 2551 right here. That s the last trade we made. So, let s say I want to put this on lay-away, okay? I come down here to where this purple one is, very easy, and I see October 11 which is 2011, not October 11, and I see 25. So, basically this says this. I come out here to the ask price where the market maker is asking, and I see that for $1.50 are you kidding me? I can put this on lay-away at 25. So, here s the stock chart and I see it here, 25 and I think it s getting a little higher. Instead of spending $25, I spent $1.50 for the right to buy it at 25. Now, if it goes up to a hundred dollars which it won t unless it does, I can buy it at 25 and sell it over hundred and make 75 bucks of share. But I

13 13 didn t have to put in the 25 bucks, I only have to put in what? The agreement money. I had to put in the premium of $1.50. So, let s do that again because I know that this is for people that are new. The last, this is the stock price. So, the stock price is I can put it on lay-away at $25 right here if I think it s going up. So again, I have to choices. I can buy the stock, right? This is the best I can with the miles. I can buy the stock if I think that will get me close to money goals and that will cost me $25. Or if I want it, too, I can buy the option. In this case, it s called the call option, and I can get that for a $1.50. Well, think about that. A hundred shares of contract, that would be, what? A hundred times 25 would be $2500, or 100 times that would be 150 bucks. So, I can put $2500 of Microsoft on lay-away and that s still a couple of months down the road and I can do it for 150 bucks. That s pretty cool. Two months out, it s August right now. Two months out, that s pretty good stuff, okay? So, let s take a look at this. Here s Microsoft chart right here with 2551 here in August. It says I can put this on lay-away at $25 here and I can do it for $1.50. The last one is It s called an option chain. So if I think, check this out, if I think this can hit 28 again, let s say there s going to be some technicals or we got support and I don t think it s taken off, I hear some good news, I see their balance sheet was good, I see the fundamentals are good, maybe the broader market started shaping up, and in my mind s eye I see this thing going to 28, well, I can do two things; I can buy it for 25 and sell it for 28, trying to make three bucks, or what could I do? I could buy it and put in on lay-away for $1.50 and let it shoot up. That means, after the fact. Now, think about how cool that is because look, if I buy it at 25 and I buy a hundred shares of $2500 and it shoots up to $2800, and 28 bucks times 100 shares, that means I ll make 300 bucks if I could ride a better of three. That s right, a better of three, I can make three bucks. But here, I put on a lay-away for $1.50. This should be $150, right? Well, if I can buy at 25 and it s worth 28 today, what s the intrinsic value of that option? Three hundred dollars. So, here I make a decent return, maybe a little over 10%. Here, you d doubled your money. Unbelievably cool stuff. So, you see why people might like the option. If you say, Do you like everybody in the option? I don t know, I usually do the option, more risk I guess. So, let s go through it. Here s your stock price. Now, let s learn some things about this. So, your stock price is 2551 and that would be here. Your strike price is $25 and that would be here. So, this is the price you can buy the stock at and this is the price you can hold on that, put on lay-away with that. So make sure if you don t get this, just keep going through it. You ll be fine. You me. I can explain stuff if I need to, okay? So, anyway, you can buy at That s the market price, but only

14 14 you can buy at $25 if you have this option. How much will it cost you to get the option? You got the ask price of $1.50. So, you can buy it at 25. You can sell it at today. Well, this is going to help us know help us know how much they re charging for this option and what it s for, okay? So look, that would be a profit of 51 cents. If you bought this option, you could buy at 25 and you could sell it at today, and I give you a 51-cent profit. So, what that tells me is this has an intrinsic value already at 51 cents. So, I know that of this $1.50, 51 cents of it is simply because of the value that it has right now. Hopefully, that makes sense. Let s do it again. I mean the repetition, I know. You have the right to buy it at 25. Today it s worth which means you re going to immediately have a profit of 51 cents, right? They re going to charge you that and I then give it you. So that s intrinsic value of 51 cents. Now, the price of the option is $ So, 51 cents of this, as for this value, here s the question: Why are they charging me for $1.50 for something that only has an intrinsic value or profit of 51 cents? Well, remember, I get a hold of this for two months, right? It s only August. I get a hold of this till the third week of October here. So, what that means is this could go higher and that s potential, and that s called time value. So, they re charging me 51cents for the intrinsic value, and the other 99 cents, what s that for? That s for the time value. So, I can always tell how much time value is in an option. This is going to be very, very important for us to understand, is that options give us time. If we go way back to the tailor s example, what did I want with the suit? I want a couple of days to decide. I just wanted some time right? An option contract simply gives me some time to let the thing develop before I have to make move. So, this time value is 99 cents. I know that if I can buy at 25, and today it s 25.51, I have an intrinsic value of 51 cents. So, those are the two types of value that make up an option. Time value plus intrinsic value equals what? What you re going to be paying. So, basically in a nutshell, think of it this way. I m paying for two things. I m paying for time to watch it and I m paying for whatever it would be worth today. You have those two together. You get an option premium. Review it, go over and over it. Soon, it d be natural you ever set that. So, let s do a hypothetical example and let s see how cool this could be. This is T. Rowe Price. What do we have right here? Technical analysis. This is called ascending triangle and it is called breaking out of an ascending triangle. We re almost at So, what do we do hypothetically? Well, you get a two-month option on this; two or three months, right? So, for the next two or three months, maybe you get a four or five month option because I looked it up to make it realistic. So here, we have a premium of 5.80, okay, and the stock is at 52, and we can buy it at 50.

15 15 So, what does that tell us? That tells me that if the stock is at 52, that s the price, but I have a contract to buy it at 50, how much intrinsic value is that? If I can buy it at 50, that s worth 52, I have what? Two dollars of intrinsic value. They re charging me 5.80, so I now have what, 380 this time. So now here s what you got to understand. We are going to go out here and someday these things are going to expire, okay? We got to understand that this 380 is going to melt away. So, by the time this is hits expiration, the time value would be up. It would be zero and the only thing we ll have is what its worth. So if these were to expire today, what s it worth? Well, I could buy at 50 and I could sell at 52, so today it would be worth what? Two bucks. But luckily, we still have a lot of time for this to go up before expiration. So, let s watch it. Oh, look at that. Another month goes by. Notice what might have happened here. Now, it s $61 here. Notice the price is at $61. But you put it on a layaway for what? Fifty bucks. So, even though it s at 61, that guy made a promise to you that you could buy it for what? Fifty dollars. Why did he make you that promise? You paid them $5 for that promise, that s why. So, now, we can buy at 50 but it s worth 61. Well, if we can buy at 50 and we can turn it around and sell it today at 61, that s $11 dollars of intrinsic value, okay? Our time is isn t quite as long as it was before. So, we re down from 3.80 to 2.50 now. So, the premium might be So, we ve gone from 11 plus 2.50 is premium. So, notice how we re losing time value but we re gaining intrinsic value. Up we go, okay? So, maybe five six month option, boom, now where gap up. We re at $71 let s say or let s say, or we ll call it 68. So stocks at 68, you can buy a what? You can buy clear down here at 50. That s why you put it on lay-away. Isn t that cool? So, you can buy at 50. You spent $5 to be able to do this. You can buy at 50, the stocks worth 68. That means you make $18 if you exercise this option. Of course, we re almost at that time, $1.20 so the total premium, Look at that, $71 and you can buy where? At 50. So, this is a real stock. So, if you now put this stock around lay-away at 50 bucks, you could now buy it at 50. Even though the stocks trading at 71, you have a contract where you have the option to buy at $50. That was the original agreement. Now you can sell it at That s $21 you make right there. Is that right? So, we know that this option is going to be worth at least 21. It s got just a little time left before it expires, maybe 60 cents worth in your premium and you can now sell that option, or what we call exchange that option. Remember, you don t have to come up with the 50 bucks. There s this place called the Chicago Board of Options Exchange. So, you simply take this option there. You do it electronically and that will give you 21 cent before. Isn t that ridiculously cool? So you just spent 5.80 and then it jumped to 13.50, then it jumped to 19.20, then it jumped to

16 16 We started out with 5.80 where all you re buying is what? Two dollars of intrinsic value, five or six months of time. Now, you got So, check it out. You do fundamental analysis. You do technical analysis on T. Rowe Price. You see the ascending triangle. I think I would lock it in. I think it s going to bust up and make it run. So, you can spend lots of money. Let s say you wanted to do a thousand shares. Well, if you remember, T. Rowe Price was at 52.50, right, where when we started. Let s see where it was. It was at 52. So, 52 times a thousand shares, that s going to earn you $52,000. Now when it went up, it ended at So, 52 times a thousand is 52 grand. It goes up at 71 times a thousand. That s 71 grand. So, you made a profit of $19,100. Thirty six percent return in one, two, three, four, five months. Pretty good. You could also buy the options for how much? 5.80, right, times a thousand shares would be $5,800. Over here, 5,800 but you get a sell agreement for what? For times a thousand. So, your profit is 15 grand for 274% return. Now, if you re not getting all these strike price and premium and intrinsic value and time value, do not worry about it. The rewards are worth persevering through to learn it. It s hard to learn at your first time sometimes. Don t worry about it. What I want you go get right now in this session, the first time through, is that when I do fundamental analysis, let s put my big FA up here, when we do fundamental analysis and then we do technical analysis, we now have a stock opinion. We say, Okay, the fundamentals look strong, PE looks good, PED looks good, earnings are good, technical chart looks good, [INDISTINCT4610] triangle, we think it s going up. At that point, you can choose a strategy that takes lots of money to harvest the move or the less money. That s all I want you to understand right now is you have a choice for leverage. I like the option because it gives more leverage. Here, I spent $52,000. Here I spent and remember it, Vfinal minus Vinitial divided Vinitial equals arithmetic return. The closer this number here, this Vinitial, if you could get zero, less money, the higher the arithmetic return will go. So, here I can get in by spending 5800 or here I can get in to control a thousand shares with 5200 or Both control a thousand shares, don t they? Five eighty times a thousand; 52 times a thousand. Both give nice profits if your fundamentals and technicals are correct but the return difference is just nine-day between the option and the stock. That s big mess. Let s erase it. END OF CASH FLOW MODULE 3