kinetic profits Huge Gains From the Market s Strongest Moves

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1 AGOR A financial kinetic profits Huge Gains From the Market s Strongest Moves Options Trading the Kinetic Way Options. The mere mention of the word is enough to send a shiver down many investors spines. But, fact is, you don t have to understand any complex options strategies to make money using them. In this report, I ll show you how you can use options to supercharge your gains, all while keeping your risks limited. First, let s take a look at how options work and how they re able to boost your trading profits An option is a tool that gives you the right (but not the obligation) to buy or sell a stock at a predetermined price on a predetermined date. A call option gives you the right to buy a stock, and a put option gives you the right to sell it. Another Way to Think About Options It can be hard to grasp how options work especially if you re new to the world of stocks. But there s a good chance you already have a contract very similar to an option. I m talking about car insurance. You can think of buying options a little bit like buying an insurance policy for your car. Think about it: Car insurance pays out when your car gets damaged during your policy cycle. Likewise, options pay out when a stock moves through a set price during the option s lifespan. Just like with car insurance, you pay a premium to purchase an option. If the option is likely to have to pay out, then the premium you pay is higher just like trying to insure your teenage son to drive your Ferrari. As traders, we re trying to buy options that act like insurance policies with cheap premiums but are still likely to pay out. Our trading system gives us the tools to do that consistently. An option is composed of a few different pieces: The underlying is the stock that the option gives you right to buy or sell The strike price is the price that the option lets you buy or sell at The expiration date is the date when the option s life ends. As a basic example, let s look at Microsoft (NASDAQ:MSFT), which was trading for $30.77 in April 2013 even though that was a little while ago, it shows you how options work, which is the important thing. Let s say you thought Microsoft was a good buy at that time that s set to move higher. More specifically, you think it will climb in price several dollars by the middle of the summer. So you buy the Microsoft July 2013 $31 call, which was trading for $1. Since one options contract controls 100 shares of a stock, you re out $100 for your trade ($1 option cost times 100 shares). First, let s break down what that specific call means: It gives you the right to buy shares of Microsoft at $31 per share anytime between now and the end of July (stock options always expire on the third Saturday of the month, unless it s a holiday). But why would you want to buy options in the first place? Well, take a look at what happens if you re right If Microsoft climbs to $34 by the middle of the summer, its stock went up just over 10% (remember, it started at $30.77). Not too shabby. But since you bought the option, you would have seen your investment climb by 200% in those same three months. How? The option gave you the right to buy Microsoft at $31 when it was already trading at $34 that s a gain of $3 for each of the 100 shares your option controls. In total, your proceeds are $300. When you take out your initial $100 cost, you re left with $200 or $2 in profit for every dollar you invested! afinancial.com

2 That s what makes options so powerful. As a real-world trader, you re not going to be right every time. So what happens if you re wrong on the Microsoft trade? Let s say that Microsoft doesn t rally for the next few months instead, let s say it falls by 10% or so. 100% Instead of ending July at $34, it ends the month at $ In that case, you re not still stuck buying 5% shares of Microsoft for $31. Instead, you re out only that $1 per contract that you paid for the option itself. 0% If you d actually owned 100 shares of Microsoft, you would have lost $307. But since you owned the option, you re out only a third of that! Your risk is always limited to your initial investment when you buy an option. Better still, you don t have to hold onto an option until it s worthless. If you figure out that your original Microsoft analysis was wrong sometime before expiration, you could sell your contract on the open market while the clock is still ticking and potentially recoup most of your initial investment. Let s take a closer look Clearing up Options Pricing Confusion A lot of investors don t understand how option prices (also called premiums ) work. In many ways, though, it s much simpler and more transparent than stock pricing! Just as with stocks, supply and demand determines option prices. That means that an option is worth whatever someone in the market is willing to pay and someone else in the market is willing to sell it for. Let s go back to our real-world Microsoft example: Going back to our previous example, the MSFT July 2013 $31 Call was trading for $1, while the underlying stock was trading for $ Since MSFT was trading for less than $31, it didn t have any real or intrinsic value its only value comes from the potential that shares will climb above $31 sometime between when you bought it and July. Options traders call that time value. Since our option has zero intrinsic value, it s considered out of the money. Buying the MSFT Option vs. Stock 250% 200% 150% On the other hand, a $30 July 2013 MSFT call traded for $1.54. Since Microsoft was trading at $30.77, that option had $0.77 worth of intrinsic value and it also had $0.77 worth of time value. This option was considered in the money since it could be exercised right now for that intrinsic $0.77 per share The market determines time value, but intrinsic value is always the difference between the option s current price and its strike price. Option Premium = Intrinsic Value* + Time Value* (* times 100 shares per option contract) MSFT Option Gains MSFT Stock Gains Day 1 Day 30 I said that option prices are simpler than stock prices. That s because you always know precisely how much intrinsic value is built into an option s price at any given time. For a company s stock, it s effectively impossible to truly understand all the variables that contribute to its intrinsic value; after all, how much do the 90,000 desk chairs or computer desks at Microsoft s offices contribute to its share price? Options skip that step. Lots of tiny hard-to-value components make up a stock price, but an option s price is made up of only two pieces: its intrinsic value and the premium market is putting on the chance that it will move higher before expiration (the time value). 2

3 How Strike Prices Impact Options In the chart on the right, $5 is an important price for XYZ Corp. For months, it had acted as a sort of price ceiling for shares and generally, resistance levels like that flip into a price floor after a breakout. So once XYZ moved up through $5, we had a pretty good indication that it was very unlikely to move back down through it. Picking an option with a strike price at that price floor provides an interesting risk/reward trade-off. options trading the kinetic way When a stock is very near an option s strike price (a situation known as at the money ), those options become Apr May Jun Jul very sensitive to any movement in the stock. In other words, a small move up in XYZ Corp. s stock would translate into a much bigger move in the option. So if we know that we have a price floor in place at $5, we re in a situation where technical analysis tell us that XYZ Corp. is likely to move up and call options with a $5 strike price will move up a lot for every small move in the stock. We ll come back to that $5 strike price in a moment XYZ Corp What happens if we pick a different strike price? The basic rule is that the further away an option s strike price is from the stock s current price, the less the option will be impacted by price moves. Picking a Different Strike Price Changes the Risk/Reward Let me show you what that means in plain English: If you pick a strike price that s far below XYZ s current price (called a deep in-themoney call), then its price isn t going to change a whole lot when the price of XYZ Corp. stock changes. For example, an XYZ call with a $1 strike price isn t going to move much when XYZ goes from $5.05 to $5.10, because it starts off with a higher intrinsic value ($4.05 per contract, to be precise) and thus you re paying more for the privilege of owning it. This type of option is expensive, but it s also relatively low risk it behaves a lot like the stock itself. On the other hand, if you pick a strike price that s far above XYZ s current price (a deep out-of-the-money call), the option s price won t be as sensitive, because all of its value is time value. A 5- or 10-cent change in XYZ isn t going to make much of a real impact on the value of, say, a $50 call option, because it barely makes a dent at getting XYZ s price closer to the share price. It ll still probably expire worthless, and that s priced into the premium you pay for the option. This type of option is cheap (it has zero intrinsic value), but it s also very high risk it s like buying a lottery ticket. In both of these opposite extreme cases, the option s value doesn t move much, because the small change in share price doesn t really impact whether or not the call option will be worth something when it expires (i.e., expire in-the-money). But for our original XYZ $5 call example, a tiny change can impact whether it ll expire worthless or not. It s important to remember that you won t always find a strike price that lines up well with your stop loss on a stock chart for instance, options generally trade in increments of $2.50 for stocks priced under $25. If there isn t an option with the strike price you re looking for, buying the next-lower strike gives you a lower-risk alternative. 3

4 So for our example, we ll go with the XYZ $5 call option How Expiration Dates Impact Options Here s the secret behind expiration dates: As an option gets closer and closer to expiration, its time value disappears. Remember, time value comes from the chance the option will move higher before it expires. So as the option s life gets shorter, the chances drop for a big move higher before expiration and so does its price. That means that an option with lots of time until expiration will be very expensive to buy because it has lots of time value left. But an option with very little time until expiration may not have the chance to play out before it expires. For our XYZ $5 call example, we ll need to strike a balance between the two. The best way to do that is to look at your trading history. Your trading strategy is going to lend itself to a specific timeframe. For example, say your average hold time is 21 days. With that piece of data, we can focus on options that have fewer than three months until expiration because historically, our average trade plays out well within that timeframe. That also leaves a hefty margin for error in place if the trade ends up taking longer. Special conditions matter too in a market where trades are taking longer to develop, it makes sense to focus on options with more time until expiration. On the other hand, you can opt for shorter times until expiration (and thus cheaper options) when the market turns fast-paced. So going back to our XYZ Corp. chart, since the breakout happened in early July, and knowing that our average trade normally takes a month to pan out, we can feel confident buying calls with a September expiration date. Putting it all together: We ve got a high probability trade buying XYZ $5 September calls. And we figured it all out from a single price chart. How to Buy Options for Half Off What if I told you that you could get a 50% discount on your next options trade? It may sound too good to be true, but today I ll show you how to do just that. First, though, to understand how to buy options at a discount, you ve got to understand risk. Too many investors think that risk is a bad thing But manage risk right, and it can become your best friend. I mentioned before that options are simple simpler than stocks, in fact. Remember, options give you the right (but not the obligation) to buy or sell a stock at a certain price and by a certain date. Only two things determine what an option is worth: 4 Intrinsic value: the difference between the strike price and the stock s current price Time value: how much the market is willing to pay for the possibility that the option will gain more intrinsic value before expiration The moment the option expires, there s zero chance that the option will get any more intrinsic value so time value drops to zero too. Keeping that in mind, we can easily figure out our reward/risk trade-off by looking at what happens to our option at different price levels. Let s use the imaginary XYZ Corp. $5 September calls that we talked about earlier as an example First, what do we know about that specific option? Well, it gives us the right to buy 100 shares of XYZ Corp. for $5 per share by the third Friday in September (in 2016, that will fall on Sept. 17). So how much the option is worth when it expires depends on the closing share price for XYZ Corp. on Sept.20.

5 For instance: If XYZ closes at $6, our options will be worth $1 per share (or $100 total for all 100 shares), since they give us the right to buy shares for $5 If XYZ closes at $5, our options will be worthless you can buy a $5 stock for $5 anyway without owning the options, right? If XYZ closes at $4, our options will also be worthless you wouldn t pay $5 per share for a $4 stock! Since options give us the right to buy XYZ for $5, we re not obligated to buy shares if it s not in our best interest. We also have to factor in costs how much we paid for the option and any commission fees from your broker get taken out of our profits too. So if XYZ closes at $7.84 on Sept. 17, our $5 call options will be worth $2.84 per share. And if we paid $1 for the option premium and commissions, then we re looking at final profits of $1.84 per share or $184 total. You get the idea. Better still, we can graph it! Assuming we paid that $1 (including commissions) for our pretend XYZ Corp. $5 September calls, the profit-and-loss graph would look like this: At a glance, you can see how at our $5 strike price, the option suddenly has value and our blue profit line suddenly turns upward. Example Call Option Profit & Losses $500 $400 When the blue line crosses the $0 profit mark, we re at breakeven on the options, and our profits now equal our $1 costs that happens when XYZ s stock is price hits $6. You can see how even though risk is limited (maximum losses are flat at $100 when XYZ s stock price goes below $5), our profits are unlimited as the blue line climbs up and to the left. Losses/Profit $300 $200 $100 $- $(100) $(200) Break-even $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 XYZ Stock Price You can create a graph like this for your own real-world options trades. Many brokers software packages have the ability to create these graphs with a couple of mouse clicks or if you re really adventurous, you can plot them yourself by hand. The important thing about this graph is that it shows you visually how your risk and reward change as XYZ s stock price changes at expiration (Note: We ll talk about what happens when you don t hold until expiration a little later on). The Basics of Writing Options For simplicity s sake, we ve focused only on buying call options up until now. And that s all we ll do as part of your Kinetic Profits subscription. But I want to quickly go over another type of options strategy that some folks use as well. In addition to buying options, you can also sell them when you sell a brand-new contract, it s also known as writing an option. Don t confuse this with selling to close an options position that you currently own when you write an option, you re creating a new contract between you and an anonymous buyer. Selling options is the exact opposite of buying them simple as that. When you sell an XYZ $5 September call option, for instance, you re taking the other side of the trade: You re giving someone the right to buy shares of XYZ Corp. for $5 by Sept

6 That also means that whoever writes that option has unlimited risk as XYZ Corp. s share price climbs higher: They still have to fulfill those shares at $5 to whomever they sold the option to. In exchange, that seller gets the premium that the buyer pays for the option. Because risks can be theoretically unlimited, I don t recommend that new options investors write options. But I do want to show you how you can tweak this approach to buy options for half off if you re new to options, think of this as a sneak peek at what you ll be able to do later. Building Your Discount Options Trade In the profit-and-loss chart I showed you earlier, the grey line looks like a stretched-out hockey stick but you can change the shape of that line (and thus your potential profits or losses) by combining different options in your portfolio. When you buy or sell multiple options on a single stock with different strike prices or expiration dates, it s called a spread. Again, I m not going to get into all the different varieties of complex spreads out there I just want to show you one basic example. Let s say that you want to buy the pretend XYZ Corp. $5 September call options we ve been using, but you don t want to pay the full $100 premium to do it. In that case, you can sell an XYZ September call option with a higher strike price and collect that premium to offset your cost. Let me show you how it works: If you think that XYZ Corp. is going to move above $5 but isn t likely to move above $10, then you could sell an XYZ $10 September call option at the same time you buy your $5 calls. If the premium on the $10 calls is 50 cents, then you get $50 to offset the $100 you re paying to buy the lower calls. It s like buying options for half off! If XYZ moves up to $7, then the $5 calls you bought are worth $2, and the $10 calls you sold (and are responsible for) are still worthless. And because your cost is lower from selling the higher strike price calls, your gain percentage is higher. But if you re wrong, your risk is still limited on both sides. Here s how the profit-and-loss graph looks: So in plain English, you re basically selling your rights to unlimited profits when XYZ goes above $10 in exchange for paying less to buy your $5 calls. Why would you want to do that in the first place? Example Bull Call Spread Profits & Losses $500 $400 If your analysis tells you that it s unlikely for XYZ to move above that $10 level, then trading off unlikely gains in favor of lower costs makes a lot of sense. And it s a strategy that can magnify your options gains even further with some practice. Losses/Profit $300 $200 $100 $- Break-even After reading this section, I don t expect you to $(100) start trading options spreads. In fact, you may want to take a break and come back for a second look at the concepts I introduced to you today this is some more advanced stuff. Use Options to Protect Against the Next Market Crash Stocks have had a great run in the last few years: As of this writing, since the market bottomed back in March 2009, the S&P 500 index has rallied more than 227%. Stocks are at all-time highs. Yes, in just a seven-year span, the biggest stocks in the world have more than doubled Just think about that for a second. We re currently in one of the biggest stock rallies in history. $2 $4 $6 $8 $10 $12 $14 $16 $18 $20 XYZ Stock Price 6

7 Buying Put Options options trading the kinetic way Until now, we ve been focusing on call options in this section. Calls are popular because buying them is a lot like buying a stock only with a ramped-up reward-to-risk ratio, as you ve seen here. But put options have a lot to offer as well. As a refresher, buying a put option gives you the right (but not the obligation) to sell a specific stock at a specific strike price and by a predetermined expiration date. What does that accomplish exactly? Basically, buying a put lets you bet against a stock. Let s say that our old imaginary friend XYZ Corp. has shares of its stock currently trading for $5. But this time, you think that the stock is overpriced and headed lower in the next couple of months so you buy an XYZ Corp. $5 June put option. Your put option gives you the right to sell shares of XYZ for $5 anytime between now and June s options expiration date (the date isn t important in this example). So if you re right and XYZ falls down to $2, your puts give you the ability to sell that two-buck asset for the full $5. You can see why that s a good thing In every other way, buying puts works just like buying calls: Your risk is limited to the cost of the options (because if XYZ s price rose above $5, you wouldn t bother with it), and the cost of the options is determined by intrinsic value and time value. With puts, intrinsic value is found by subtracting the option s strike price from the stock s current price. In a big way, put options are a lot like insurance. When you buy a $200,000 homeowners insurance policy for your house, you re saying that you want to be able to get $200,000 for your home even if a spaceship smashes into it while you re out of town. With our XYZ put example, you re saying that you want to be able to get $5 for shares of XYZ even if some catastrophe destroys shares value. So if put options are like insurance, you can use them to protect your whole portfolio. For instance, you can buy a put option on a market ETF like the PowerShares QQQ Trust (NASDAQ:QQQ), which tracks the Nasdaq-100 Index and get paid out when the stock market drops! (Since the Nasdaq-100 is a little more volatile than, say, the S&P 500, we ll use that as our example. After all, our put will pay out more with an index that takes a bigger hit!) Insuring Against a Crash To insure against a crash, you need to buy a put option with two characteristics: It s got to be cheap, and it s got to have plenty of time to play out. The best way to do that in one step is by buying a long-term put that s way out of the money Remember, you want to minimize the cost of your portfolio s insurance policy. That cost has two factors: time value and intrinsic value. We need plenty of time on our insurance policy so unfortunately, our time value is going to cost more. To make up for that higher time value, we ll use a put option that has zero intrinsic value. That way, our insurance policy only pays out on a really big move down, but it s cheap to buy. So let me show you how that would work with our QQQ example In 2014 QQQ traded for $69.36 per share. And, we wanted our insurance policy to kick in if the index crashes in that case, we could buy the QQQ $50 January 2015 put. That put gives us the right to sell the ETF for $50 per share anytime between when we bought the option and January (In the real world, we d use a little more analysis to pick our strike price and expiration, but this put will get the point across.) 7

8 That option cost $1.83 at the time, which means a total investment of $183 for a contract ($1.83 per share times 100 shares in a contract). That $183 cost is what you re paying to insure your portfolio Buying Jan 2015 QQQ Puts as Portfolio Insurance $3,500 $3,000 $2,500 Here s what the profit-and-loss graph looks like for that put option: In the graph on the right, you can see how you re out a flat $183 if QQQ stays above $50. But if the market does crash and QQQ falls through $50, your insurance policy starts paying out: If QQQ hits $48.17, you re at breakeven for the trade (you ve made enough to cover the premium) If QQQ falls to $45, you re sitting on gains of $317 And if QQQ drops all the way to $25 (like it did in 2008), you re up a whopping $2,317. I should note that your gains could actually be much bigger than that. Remember, the graph above only shows your profit from the put option s intrinsic value. If QQQ crashes with enough time until expiration, this option s time value could get huge and you could sell your option well before expiration for a big profit. Just like a regular insurance policy, if you don t use it, you re out only what you paid for your premiums.if you do use it, then it helps to offset the losses in the rest of your portfolio A Quick Word on Greeks Losses/Profit $2,000 $1,500 $1,000 $500 Options Greeks are a more advanced concept that s worth understanding even for casual options investors. The Greeks are numbers that tell traders how sensitive an option s time value is to a number of different factors like the price of the underlying stock or the passage of time. They get their name because they re represented by Greek letters. These numbers can usually be found on your broker s trading platform. Here s the rundown on the three most important Greeks: Delta (Δ): an option s sensitivity to the underlying stock s price (i.e., how much the option s price changes when the stock changes by $1) Vega (v in this case, not actually a Greek letter): an option s sensitivity to volatility (i.e., how much the option s price changes in a more volatile market) Theta (Θ): an option s sensitivity to time (i.e., how much the option s price changes as time left until expiration ticks away) Since traders always want to know how much their options position will change when the underlying changes, delta is certainly the most popular of the Greeks. But that doesn t mean that investors should just ignore the others. Theta is an especially important concept for options traders to understand since it determines how quickly an option s time value erodes away. Because time value is often a bigger component of an option s price than its intrinsic value, theta can play a big role in options pricing even if most traders have no idea what it is Remember, time value is the premium the market is putting on the chance that it will move higher before expiration. So as the option gets closer to expiration and the chances of a big move higher in the underlying stock decrease, so too does time value. Theta just measures how fast it happens. One important takeaway from the chart of theta is that the value of the option starts to decay more quickly once there are only 30 days until expiration at that point, the market figures that a major move becomes dramatically less likely with every day that passes until expiration. $- $500 Break-even $70 $65 $60 $55 $50 $45 $40 $35 $30 $25 $20 $15 XYZ Stock Price 8

9 Trading Considerations of Options In general, the same risk management procedures we use with stocks in Kinetic Profits carry over to options trades. Because options tend to be more thinly traded than their underlying stocks, we always use the underlying stock to set important technical levels like stop loss prices and target prices. At the end of the day, options trades are just a way of ramping up our reward-to-risk trade-off, so it makes a lot of sense to keep our technical focus on what the stock is doing. Our options trades are just along for the ride Position sizing is a key part of the risk management process it ensures that you can withstand a loss in your portfolio and still survive to trade another day. Generally speaking, you should avoid taking options positions that are more than 2% of your trading capital. In some cases, high options costs will make it difficult to stick to that 2% benchmark. In those cases, you can lower your costs by sliding down to an option with a lower strike price just keep in mind that you re increasing your risk level by doing so. Up until now, we ve talked about the profit or loss opportunities of holding until expiration because it s easier there s no time value to factor in. Since the market determines time value, it s impossible to predict exactly how much it ll add to an option s price at a certain point in time. But that doesn t mean that you have to hold onto options until they expire. Just like a stock, you can sell your options into the market and collect whatever new buyers are willing to pay. (Hint: When you sell before expiration, it will always be for at least intrinsic value plus some time value, depending on the chances of a move higher by expiration.) Most options traders trade out of their positions long before they expire. Trading out avoids the added costs and complications of actually executing an option and then selling the resulting stock on the market to collect your gain. Barring extremely rare situations, we always trade out of any options positions in Kinetic Profits. When traders do hold until expiration, there are two possible outcomes: If an option is out of the money, it just expires worthless and nothing happens. Around 75% of all options end up doing nothing. If an option is in the money when it expires, it ll be automatically exercised by your broker for a call option, that means you ll end up buying 100 shares of the stock at the strike price for each option contract you own. It s one of the few times that your broker will act without instructions from you so it s important to keep in mind. Most of the time, exercising an option incurs an additional fee from your broker, and then selling the resulting stock racks up even more commissions, so unless you actually want to own shares, it s usually a much better bet to sell the option before it expires. Because options tend to be more thinly traded than stocks, I recommend always using a limit order to buy them. A limit order lets you set a maximum that you re willing to pay to get your order filled and it ensures that you re not setting yourself up for an instant loss if there s a big bid-ask spread in the option s price. It s also important to remember that your broker probably uses a different commission structure for options than for stocks make sure that you understand the fees for trading options before you click the buy button Regards, Jonas Elmerraji Editor, Kinetic Profits Copyright by Agora Financial, LLC. 808 St. Paul Street, Baltimore, MD All rights reserved. No part of this report may be reproduced by any means or for any reason without the consent of the publisher. The information contained herein is obtained from sources believed to be reliable; however, its accuracy cannot be guaranteed.