reply posted on 26-8-2007 @ 05:15 PM by Tom Bedlam
Ok - FYI, the tickerforum site seems to be at least technically correct.
The 'anomalic research' site is very messed up - if you read this site other than for fun, you will become very confused as to what's going on.
They have it wrong, and worse, they flip-flop on the point several times.
Someone bought put options. THAT is the bet that the stock market will drop. Selling put options is a bet that it will not.
I used to trade a lot of commodities as a hobby - don't have time for it now, so I was really up on this stuff at one time. It pretty much translates
over into stocks in terms of technical terminology, so let me see if I can dredge this up from memory correctly. It DOES get to be confusing.
An option is an instrument that gives its buyer the right to purchase or sell the underlying instrument at a certain price, by a certain time. For the
seller, it is an obligation, not a right.
Let's look at that. Let's say I own an acre of land. I don't think the city is going to build out that way. If it did, the land would be worth a
lot more. If not, it's good for growing hay, which is what I'm doing with it now. The land currently appraises at $5,000.
A guy comes to me, and this guy thinks it's going to be prime mall property a year from now. I don't. So I sell him an option to buy the land for
$5,000, with a time limit of one year, at a price of $1000. This means that I just made $1,000 for my risk that the land will be worth a lot more.
That risk will last for a year, the option's term. At the end of the year, the option will expire. If the land is worth $5,000 or less, the option
will expire worthless. If the land is worth more than $5,000, I will receive the money I got in selling the option, $1,000, and the $5,000 that the
option entitles the buyer to buy the land for, and I won't have the land anymore.
I can't make more than the $6,000 on the deal. However, I can lose a huge amount of profit, much more than the $6,000, because the land may now be
worth $50,000 an acre in a year if the city expands that way. As the seller of the option, I am bound to sell it for the $5,000. It is an obligation
to me.
From the point of view of the buyer of the option, I am hoping the land goes up in value. If it does, I am entitled to buy the land for $5,000. It is
a right, but not an obligation. I do not HAVE to buy the land for $5,000, or any amount. The option has possible "real value", that is, if I bought
the option at or in the money, and "time value". Time value is related to the time that the option still has to run, and is affected by volatility.
If the land market is really bouncing around (maybe the city hasn't decided), then the time value will be inflated. As time runs out, let's say I
only have a week before my option expires, and the city STILL hasn't decided, I may have lost my $1,000, because the time left for them to do so is
very short before my option runs out.
Since the buyer has the option to buy the underlying instrument, the acre of land, at a fixed price in the future, this would be a "call" option.
Call options can be bought and sold. As the buyer of a call option, I'm hoping the underlying instrument increases in price - I'd like to buy a
$50,000 parcel of land for $5,000. As the seller of a call option, I'm hoping the land's value decreases or remains the same (if it's out of the
money), because then I get to pocket the option payment as free money. The term "call" is used because the buyer can "call it away" from me. (I
know it's stupid)
So, options have two values - time value, which is affected by volatility and the remaining time, and real value, which is related to how far "in the
money " they are.
Since the land appraised for 5K, and as the seller I sold him an option to buy it for 5K, it is "at the money". "At the money" options mean it
strictly has no cash value, but as the seller of the option, I'm afraid that it might be worth a little more than appraisal, or that minor
fluctuations in land value will cost me some profit if he exercises the option, so an "at the money" option will carry some "uncertainty value" as
well as "time value".
Had I sold him the option to buy it for $4,000, well, the land is worth $5,000, so that sort of option would be "in the money". "In the money"
options have both "real value" in this case $1,000 of real value, since the land is worth more, and "time value", which represents my risk the
land will increase in value. In the money options cost more, because you're sort of partially buying the land. I might sell you an in-the-money call
option if I'm convinced the land will DROP in price, because then I'll make your time value and real value. Let's say I know there's a superfund
dump site on there, sell you a call option at $4,000, for a fee of $2,000. Now you have the right to buy it from me a year from now for only $4,000,
but when you get around to looking at it more closely, you'll see that you have an acre full of benzene or something and run away. I get to pocket
the option fee of $2,000.
Had I sold you the call option to buy the land at $10,000, then there is only time value. I'm betting it will go up in value, but not that much in a
year.
Now, if I sold you that call option to buy my land at $5,000, and the land ends up worth $50,000, then at the year mark, you will "exercise" your
option, and I will have to sell it to you for $5,000, losing the land. You might also just sell the option at a profit before that time, and let
someone else exercise it.
PUT options are the reverse - and they're a bit less intuitive than a call option.
In a put option, I don't own the underlying instrument - but I'm betting it will go up in price. So as the seller of a put, I undertake an
obligation to buy it at a fixed price in the future. Let's go back to the acre of land.
My next door neighbor has 100 acres of land he'd like to dump. He's betting that the EPA will find the benzene contamination and it will be
worthless. I'm betting that the city will annex us, and I secretly know that the benzene contamination was a bad soil sample. I don't have the money
to buy 100 acres of land. But I want to cheat my neighbor out of some money, so I sell him a put option. Basically, as the seller of the put option,
this put option gives me the obligation to purchase the 100 acres of land a year from now, at $5,000 an acre. I don't have $500,000. But that
doesn't matter, because my cousin on the annexation committee let me know that the city is a week away from annexing it.
For the burden of having to buy the land at $5,000 an acre a year from now, I am paid $10,000 by my neighbor. So, he's out $10K as the purchaser of
the put option, and as the seller of the put option, I just made $10K.
From his point of view, the land is full of benzene contamination and will cost a fortune (and be worthless) to clean up. He just paid out $10,000 for
what he thinks is the right to dump the land on me next year. As the seller of that put, it is my obligation to buy it. As the buyer of the put, it is
my neighbor's right but not his obligation to sell it to me at that price.
A year goes by - and the city has annexed the land. It has no real contamination, and the land is now worth $50,000 per acre. My neighbor will NOT
exercise his option to sell me the land for $5,000 - it's worth ten times that - so the option will expire worthless. I made $10,000 for taking the
risk as the put option seller. The buyer of the option - my neighbor - is only out the initial option fee. He has no other risk. The seller of the
option - me - is potentially out $500,000 if the year passes and the land IS worthless. But in this case, I knew that it would be going up in price
and made some free money.
Put options can also be in, out, or at the money, and also have time value and can have real value. It's just harder to see it with a put option.
Put options
seller: Has nothing, is hoping the underlying instrument will go up in price. Makes the option fee up front. Will end up with the underlying
instrument if the value drops low enough to put it below the option strike price and the buyer exercises. Has a legal obligation to buy at the option
strike price.
buyer: Owns the instrument, and is expecting the underlying instrument will go down in price. Pays out the option fee up front. Has the right but not
the obligation to sell the underlying instrument to the option seller at the option strike price. i.e. "put it to him" at the strike price. Let's
say the land is worthless, the buyer can sell the land to the option seller at the strike price anyway, "putting the land to him" at an inflated
value.
call options
seller: Owns the underlying instrument, is expecting the underlying instrument will go down in price. Makes the option fee up front. If the value goes
up instead, the option buyer may "call it away from him" at a low price. Makes the fee up front. Has the legal obligation to sell the instrument at
the strike price.
buyer: Pays the fee up front. Hopes the underlying instrument will go up in price. If it does, he will exercise the option and "call it away" from
the seller at a cheap price.
That's real simplified, but it's pretty much right if I didn't have a brain fart. There are all sorts of complicated things you can do that I
don't touch on, like spreads, straddles, hops, in or at the money options, time spreads, calendric spreads etc that use differential values to make
money of the decay of the time value and the like. But you see that more in commodity trading than you do stock trading. It's even weirder in
commodities, as you're selling something you don't own to someone that doesn't want it etc.
So, the BUYER of the put option is betting that the market will tank. NOT THE SELLER. The guys on "anomalic research" or whatever it was are wrong.
The sellers are betting it won't go down that far. If it does, they'll end up owning worthless stocks. The sellers of the put options are betting
that the market will grow in value, or at least not fall that far.
