Shorting a Put

You are shorting or selling a put. Easy derivatives trade you may very well want to do in real life some day. So let’s frame things here first.

A put is the right to sell a security. For now, just think about selling puts on shares of a normal, liquid, publicly traded company. And this makes sense, because in reality, oddball names that trade only small volumes just don’t get big markets made in them by the banks who trade in them; the spreads are so high that trading at all makes almost no sense. So think: shares of a volatile name, but one that's liquid.

Think: GE in the modern era. It trades a gazillion shares a day. Very liquid.

You liked the stock when it bottomed around 7 or 8 bucks a share. You bought it big: 100,000 shares. And waited. Then there were takeout rumors that Warren Buffett and Berkshire Hathaway were going to buy it. The stock popped to 15 bucks a share on the whispery rumor, and at that point, you sold your long position, i.e. the shares you just bought like a normal human in the marketplace at an average cost of 7 dollars 52 cents. You sold them after doubling your money in 3 years, and you felt good about that score.

Buy low. Sell high. Long-term gain, cheaper tax treatment. Easy.

But you felt that your love affair in making money off of GE stock wasn’t over. You had more, um, love-making to do. You watched longingly as the stock slipped back to $11 and a quarter from a peak of 15-eighty, on Buffett’s and Berkshire’s fervent denial that they were buying the company.

But the company was beginning to be perceived differently, from something that was dead...to something that was...recovering, albeit slowly. But that had real value. And you mused that if it wasn't Berkshire and Buffett buying the company, it’d be someone else, some day.

But that day might be a very long way off. So you feel good about the stock at 11 bucks and change. You feel good about its prospects long-term. You feel that it should at least be a market performer, growing maybe a dollar a year for a few years from here, boringly doing generally just okay. Not exciting enough to buy the stock in a vanilla, basic, long, non-Fifty Shades kind of way.

Importantly, you notice that, in the crazy-ish volatility of the rumored buyout, and the spike then decline in the stock price, the derivatives markets “went nuts.” That is, a bunch of put and call option owners got massively jerked around in this huge stock price change, with shares that had hovered around 8 or so bucks a share for almost a year, like a dead man’s pulse.

So today, with the derivatives traders hugely stressed out, you think there’s a way you can take advantage of their nervousness. And you decide to execute the "dead money trade." That is, you think that, at 11 bucks a share, GE is pretty much dead money for a while...that it’ll go down to 10 on bad market days and maybe waft to 12 on good days, but that it's just going to be “meh” for at least the next 3 or 4 or 5 months.

So you’re going to short or sell a put option. In doing so, you’re going to sell someone else the right to “put their shares” to you, or to force you to buy their shares at a given price over a given time period, if the math makes sense for them to do so.

That is, you’re going to give them the right to sell you their shares of GE at a set price over a set time period. And, in return, you’re going to collect premium from them. They think of the premium they’re going to pay you as share "term life insurance." You look at the numbers. And you think that, if you just “had to” buy a ton of GE at 10 bucks a share today, you’d be fine with that. At 10 bucks, you think the shares trade at just 10 times the dollar a share the CEO has signaled they’ll earn next year, and if you had to be just a big owner of the stock, then…fine. You’ll own a ton of GE at a cost basis of 10 bucks. So you decide to anchor 10 bucks as your strike price in this put option. That’s the “long price” at which you’d be happy just buying a ton of GE.

You’re going to collect term life insurance for this stock. The nervous nelly derivatives trader on the other end of your trade is offering to pay a dollar a share, such that she has the right to sell you GE shares for 10 bucks each, meaning that she thinks there’s decent odds that the company trades down to 7 or 6 or 5 bucks a share in that time period. And she’s happy to pay a dollar a share for the life insurance so that, if the stock does trade to 6 bucks a share, she can just force you to buy it at 10 bucks.

So when you collect that dollar from her, if you then had to buy the GE shares at 10 bucks each, your net cost per share would, in fact, be 9 bucks. And at 9 bucks, you think the stock is just stupid cheap, and that it’s a screaming buy, and if your short put trade “blew up,” and GE did trade down to 7 bucks a share...yes, you’ll have lost two dollars a share buying and being long a ton of shares at 9 bucks, but you still think it gets to 15 bucks in the next 3 years, so you’ll be just fine sitting on those shares, long, and holding them. Snuggly.

So that’s more or less the worst case outcome, saving the potential that, in fact, GE ends up going bankrupt and you lose everything. But that feels like a stretch at the moment, anyway. You think Nelly is nervous for no reason. She only looks at charts and technicals. You study the fundamentals of the company, so you know more than she does about how GE is really doing operationally. You have your 10 dollar strike price. At that price, you feel great about having to be very long the stock at 9 bucks with that dollar premium you've collected.

And you note that, if you wanted to be exposed to that term life insurance for GE for only 10 weeks, instead of 20 or 25 weeks, then you could take in just 50 cents of premium and be done with it.

If you did that shorter-term short put trade, you’d collect 50 cents a share and then have just roughly 50 trading days to wait and hold your breath…and with the stock trading right now at 11.25, if it stays above 10 bucks, then the 50 cents you collected per share ends up being fully owned by you. Just as if you were a term life insurance company. The time expires...or in derivatives speak, the theta decays...and you’re done. You’ve made 50 cents a share for doing nothing more than taking on the risk or liability of having to buy a load of GE at 10 bucks a share within those weeks when you were, um...exposed.

But you think GE is dead money for longer than just a couple o’ months and change. You think it’s dead money for 4-5 months...so it’s March now, and you decide to sell the September 10 puts. When you do any of these kinds of derivatives trades, you don't give the actual date that the options expire, because by default, they always expire on the 3rd Friday of the month. So...this September, that expiration date happens to be September 17th. You’re thus exposed to GE stock through March today...then April, May, June, July, August...and then, by September, this put option expires and...goes away.

And note that, because you’re taking so much more time, or theta risk, you got to collect a full dollar in premium (and yes, think of it like a term life insurance premium...that’s where the name comes from) versus that very short risk frame of 2 ½ months, where you only collected 50 cents for guaranteeing you’d buy GE for 10 bucks a share in that period.

So… hings trundle along, and 2 months in, you’re in the doldrums of summer. GE dips to 9 bucks. The trader on the other side can, in most cases, force a conversion; that is, they then execute the right to put their shares on you. You then must buy them out at 10 bucks and be very long the stock, i.e. you’d own a lot of shares.

In practice, with just a breakeven position here where you’d collect your dollar of premium, and the trader on the other side of the trade would just be unwinding her position, the early execution doesn’t happen all that often. Had GE stock gone to 5 or lower, then it likely would.

It’s noteworthy that these are American style options, not European ones. American options execute or can be converted on any day until their expiration, whereas European style options only convert on their expiration date.

So there is essentially more option, or optionality (like Wessonality) value in American options, which you can think of as a series of options that have theta decay, decaying entirely each day along the way to their expiration. Like...so many trading days need to pass with the stock above 10 bucks for you to get fully paid.

But in this case, the stock bounces off of its lows of 9 bucks, kisses 11 again and just remains there another month and change when that 3rd Friday in September happens, and it expires fully. You’ve collected your dollar a share: 100% profit. And done little more than be nervous during that summer when the stock was kissing breakeven, i.e., if it was put to you at 10 bucks when it was trading at 9 bucks and you would have then still collected your dollar in premium.

And note that, as the put gets closer and closer to that expiration date, even with a dead flat stock price of $11.25 day after day after day, that put option becomes gradually less valuable.

All this is generally good news for you, the un-nervous Nelly. Until you get your tax bill, all gains from these types of trades, even if you had let them run over a year, are taxed as ordinary income...so if you live in a Blue State, you pay, eh, 40-45 percent tax, and more or less split half your profits with the government.

And had the stock actually taken off and gone to $20 a share in this time period, as Buffett and gang did decide to buy the company, then you, the short putter, would have only collected your dollar in premium. Nothing more. So, just like that, your sordid love affair with GE is over. Don’t worry though...there are, uh, plenty of other options in the sea.