Options Trading Is Actually Simple
A few weeks ago, I had my Rich Dad advisor Andy Tanner join my team’s weekly meeting. During these meetings, we often discuss current economic events as part of our continued financial education.
In this particular meeting, we discussed the Robinhood IPO.
Before Robinhood’s IPO, some experts argued that Robinhood and other meme stocks didn’t have what it takes to be a successful IPO. Since then, the IPO has taken place and although it was initially deemed “lackluster,” it has come roaring back to life.
But what our team learned from Andy might make the biggest impact on your future as an investor.
Wall Street investors know, the only person making money in options trading is the seller.
Whether that’s true or not, I can’t say. I do know if you’re uneducated, then most likely you will lose money.
Sell Options for Income, Buy Options for Protection
A member of the staff said, “So if I understand, you sell options for income, and buy options for protection.”
I thought that was a really simple way to explain the thought process, but since I am not an options trader, I thought I would have Andy explain.
Options trading explained by Andy Tanner:
Options Trading Example: The Parable of the Suit
Imagine you knew of a simple process to create money almost out of thin air, and you could follow this process again and again whenever you needed it.
Let me walk you through a financial parable to explain how this principle works.
One day, a man walked through his town, peering into the different shop windows along the way. At one particular shop, a beautiful suit caught his eye. So he entered the clothing store and asked the clerk in the store the price of the suit.
“Well,” said the clerk, “this is a very nice suit made of the finest wool. The regular price of this suit is $2,000. Fortunately, today is the final day of a special sale, so the suit is available for just $1,000.” The shopper recognized this as a great value. But, he didn’t have enough money to purchase the suit at that moment.
The man asked, “Is there any other way I can have this suit at this discounted price without paying for it now?” The clerk, wanting to preserve the sale, replied, “I’ll propose a gentleman’s agreement. We’ll put the suit on reserve so no one else can get it, as long as you return within 30 days to pay for it in full at the discounted price of $1,000.”
The man felt very good about the agreement proposed by the merchant. He was hopeful that he could come up with the money after paying his expenses that month, but he also felt good that he was not obligated to buy the suit just in case it did not work out.
So the man agreed to put the suit on layaway, and the clerk put it in reserve at the discounted price of $1,000. As proof of this arrangement, the clerk gave the man a slip of paper with the store name, the clerk’s name, the terms of the layaway agreement, and his signature.
Options Trading Simplified (A Promise and A Choice)
The man could present that slip of paper at any time within thirty days to receive the suit at the sale price. The clerk, acting on behalf of the store, made a promise to sell the suit at a specific price for a certain amount of time. The man had the choice to purchase the suit according to those terms. Even more important, the man has no risk of loss.
The next morning, the man woke up and turned on the news. The main story was about a very popular sports star, and the athlete was wearing the same suit that he put on layaway.
Later, the man passed the same shop where he purchased the suit. The store was overflowing with people and there was a line forming just to get in. They were all trying to buy the suit that the athlete was wearing.
Upon hearing this, the man asked a young person in line, “You’re willing to buy the suit for the full price of $2,000?” At this, the young man laughed, “I wish I could get it for $2,000. The price went up this morning to $4,000!”
Overnight, the price of the suit doubled based on the new demand for it. The man’s mind started turning. He realized that there was now a line of people who were willing to pay up to $4,000 for this same suit. Yet, in his pocket, he had a layaway slip that guaranteed him the right to purchase the suit for just $1,000.
Even more interesting was the fact that those people in line were nervous that the store may sell out of all the suits before they get a chance to buy one. His suit was put away safely in the back of the store where no one else could buy it.
He considered what someone might pay him for his suit that was on layaway. He had two possible ways to take advantage of this situation: He could go into the store, buy the suit for $1,000, and then turn around and sell it to someone else for $4,000. Or, he could just sell his layaway slip for $3,000.
Both scenarios would result in him pocketing $3,000. But the first one would also require that he use $1,000 of his own money to get the suit out of layaway. He realized selling the slip of paper in his pocket for $3,000 was the best choice for him since he didn’t have $1,000 of his own money to start the transaction.
He approached the young man in line again and asked him if he would be interested in making a deal. He explained that he will sell his layaway contract for $3,000, which will entitle him to get the suit for $1,000, and he is guaranteed to get the suit. The young man quickly realized the value of that slip of paper and agreed to buy it. Without spending a penny of his own money, the man made $3,000 in a day.
How Options Trading Works
Referencing the story above, consider if this man was looking to flip a house, buy stock, or buy gold. This is the same scenario that investors exploit every single day. Amateur investors ask amateur questions like these:
“Should I use my own money to buy this house and then hopefully flip it for more?”
“Should I buy 1,000 shares of this stock and hopefully sell it later for more?”
This type of investment profit is called a capital gain. It’s when your ending investment value is worth more than what you paid for the investment. It’s the increase in your investing capital. And it’s the approach that follows the “it takes money to make money” path.
Most people believe that you find a good potential investment, pull money from your bank account to pay for it, and then hope it goes up in value so you can make more money than your initial investment.
But remember, the man in this parable didn’t ever buy the suit. All he did was enter into an agreement with someone else. And this agreement cost us no money. The store clerk gave it to us. Instead of requiring money, all we needed was a simple negotiation. The layaway agreement gave us the flexibility to decide if it was valuable enough for us to take action. It didn’t require any money from us — either from our own account or from a loan.
Options trading works the same way. You never need to actually buy a stock trading with options. Instead, options trading allows you to enter into an agreement with someone giving you the choice to purchase the stock at a specific price at a specific date in the future.
It’s not easy, of course, to always know where the price of something will be next month or next year, but it might be very exciting for you to discover that in real life there are deals you can do that don’t require you to buy anything.
Play it smart,
Editor, Rich Dad Poor Dad Daily