Short The Basis

and finance Allah shmoop How does shorting a put work

Oh okay people your shorting or selling a put option

Easy derivatives trades You may very well want to do

in real life someday so let's frame things here first

To review a put is the right to sell a

security For now just think about selling Puts on the

shares of a normal liquid publicly traded company in 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 So the spreads

are so high that trading at all in those exotic

weird derivatives makes almost no sense So when you think

normal liquid publicly traded company think shares of a volatile

name but one that's liquid like G E In the

modern era it trades a kazillion shares a day It's

very liquid Well you liked the stock when it bottomed

around seven or eight bucks a share You bought it

big 100,000 shares and then you waited Then there were

takeout Rumors that Warren Buffet and Berkshire Hathaway were going

to buy the company in a stock popped a $15

a share on that whispery rumor And at that point

you sold your long position I e the shares you

just bought like a normal human being in the marketplace

At an average cost of $7 a 52 cents U

then sold them after been doubling your money in three

years and change 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 G E stock wasn't over You had

Mohr you know lovemaking To dio you watch longingly is

the stocks slipped back to $11 in 1/4 from a

peak of 15 80 on buffets and Berkshires fervent public

denials that they were buying the company We're not buying

G I keep telling you people we're not buying it

Okay so in the process the company was beginning to

be perceived differently like from something that was dead to

something that was recovering albeit slowly but that had real

value So you amused But if it wasn't Berkshire and

buffet buying G it'd be someone else's someday But that

day might be very very far away or long way

off So you feel good about the stock here at

11 bucks and change You feel good about its prospects

a long term and you're thinking maybe the stock grows

a dollar a year for a few years from here

going to 12 Boring boring Lee Generally okay not exciting

not exciting enough to buy the stock in a vanilla

basic long you know non 50 shades kind of way

Importantly you notice that in the craziest volatility of the

rumored buyout and the spike then decline in the stock

price that the derivatives market quote went nuts unquote That

is a bunch of putting call option owners got massively

jerked around in this huge stock price change with shares

that had hovered around eight or so Bucks share for

almost a year like a dead man's pulse So then

today with the derivatives traders hugely stressed out will you

think there's a way you can take advantage of their

nervousness and you decide to execute what's called the dead

money trade That is you think that at 11 bucks

a share G is pretty much dead money for awhile

that it'll go down to 10 on bad market days

and maybe walk to 12 on good days but that

it's just gonna be me Meg for at least the

next three or 45 months maybe longer So you're going

to short or sell a put option on G Well

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 GM

set price over a set period of time And in

return you're going to collect premium from them They think

of the premium they're going to pay you as share

or stock quote term life insurance unquote And you look

at the numbers while the trading sheet looks like this

and you think that if you just quote had Teo

unquote by a ton of Gaea 10 bucks a share

today you'd be fine with that You think the shares

traded just 10 times the dollars share that the new

CEO of Gaea signaled that they'll earn next year And

if you had to be just a big owner of

the stock for a long period of time then fine

You alone a bunch of Gaea cost basis of 10

bucks So you decide to anchor $10 as your strike

price in this put option That's the quote long price

unquote at which you'd be happy just buying a bunch

of G E stock But wait there's more You're going

to collect term life insurance for this privilege on this

stock The nervous Nellie 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 Yugi

shares for 10 bucks each meaning that she thinks there's

decent odds that the company trades down to seven or

six or five bucks a share in the very near

time period of a few months And she's happy to

pay a dollar a share for the life insurance Teo

you know make that security happen in her head If

that stock does trade to six bucks a share she

can just force you to buy it at $10 a

share So when you collect that dollar from her if

you then had to buy the G shares at 10

bucks each well then your net cost per share would

in fact be nine bucks and it nine bucks You

think the stock is just stupid chief and that it's

a screaming by And if you're short put trade quote

blew up unquote and G did trade down to seven

bucks a share Yes you'll have lost $2 a share

in buying it And being long then Aton of shares

at nine bucks your cost No but you still think

it gets to 15 bucks in next three years so

you'll be just fine sitting on those shares long and

you know holding them you know snugly So that's more

or less the worst case outcome saving the potential that

in fact he ends up going bankrupt and well then

you lose everything but Teo you that feels like a

huge stretch at the moment Anyway you think Nelly is

nervous for no good rational reason She only looks at

charts and technicals but you study the fundamentals of the

company and you know more than she does about how

g e is really doing operationally So you have your

$10 strike price at that price you feel great about

having to be very long stock at nine bucks with

that dollar premium you would've collect And you know that

if you want to be exposed to that term life

insurance for G for only 10 weeks instead of 20

or 25 weeks well then you could just take in

50 cents of premium and be done with it sooner

So if you did that shorter term short put trade

you'd collect 50 cents a share and then have just

roughly 50 trading days toe wait and hold your breath

And with the stock trading right now at 11 25

a share if it stays above 10 Bach's well then

the 50 cents you collected per share ends up just

being fully owned by you Justus if you were a

term life insurance company and that month the guy didn't

die the time expires Or in derivatives speak the data

decays to zero 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

G stock it 10 bucks a share within those weeks

when you're you know exposed But you think GI is

dead money for longer than just a couple of months

and change You think it's dead money for 45456 months

something like that So it's march now and you decide

to sell the September 10 puts And yes that's the

nomenclature When you do any of these kinds of derivative

trades you don't give the actual date that the options

expire because by default they always expire on the third

Friday of the month So this September that expiration date

happens to be September 17th your thus exposed to G

stock through March today than April May June July August

and then by September This put option expires in Mill

just goes away and note that because you're taking so

much more time orthe ada risk you got to collect

a full dollar in premium And yes we're talking about

premium life insurance here loosely That's where it comes from

versus that very short risk timeframe of two and 1/2

months where you would have only collected in a 50

cents for guaranteeing you'd buy G for 10 bucks a

share in that time period so things tryingto long and

in two months later you're in the doldrums of summer

and G dips to nine bucks a share Well guess

what 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 box and then you'd be

very long The stock I you then Oh nah Lot

of shares in practice with just a break even position

here where you'd collect your dollar a premium and the

trader on the other side of the trade would just

be unwinding her position While the early execution doesn't happen

all that often had G stock condo five or six

box or lower While then likely you'd be put those

shares way early It's noteworthy that these Air American style

options by the way not European ones American options execute

or can be converted on any day until their expiration

whereas European style options on ly convert on their expiration

date So there is essentially Mohr option or Optionality you

know kind of like Wesson ality at least that kind

of value in American options over European ones American ones

you know which you can think of as a siri's

of little one day options that have faded decay decaying

entirely each day along the way to their expiration Like

so many trading days 114 or whatever left need to

pass with the stock above 10 bucks for you to

collect your full life insurance premium there But in this

case the Stuck then bounces off its lows of nine

bucks It kisses 11 again and just remains there another

month and change when that third Friday in September finally

happens and the put option expires fully well you've collected

your dollar share it's 100% profit to you and you've

done little more than be nervous during that summer when

the stock was kissing break even to you I eat

If it was put to you a 10 box when

it was trading at nine bucks then you would've still

collected your dollar in premium and just be very long

the stock at nine bucks 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 like here the likely values as it goes along

the way So all this is generally good news for

you The Unnerve Assn Ellie until you get your tax

bill all gains from these type of trades even if

you had let them run over a year are tax

as ordinary income So if you live in a blue

state you pay a 40 45% tax and mohr 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 Buffet and Gang did decide

to buy the company well then you the short put

er would have on ly collected your dollar in premium

and nothing else So just like that your sordid love

affair with G is then over But don't worry though

there are plenty of other options in the sea Hey