Spread Trading: An Introduction to Trading Options in Nine Simple Steps

CHAPTER 16

R&R for Shorty

Shorty was equally anxious to find Sharon.

“Look,” he exclaimed, “I found a new way to make money. Lon and I call it shorting put options.”

“Doing what?”

“I know it sounds funny. All I mean is that I’ve found a new way to make money on deals where I’m selling something and taking in a credit. Here’s what happened. I talked to Lon, and he wanted to enter a trade on Nextall, one of the stocks I own. I paid $40 for my 100 shares and they’re currently trading at that. Well, Lon thinks the stock price might go down quite a bit, so he offered to pay me $1.50 per share to have the right to sell me his 100 shares at a strike price of $35. We decided to call this a put because he’s buying the right to put his shares over to me, or on to me, and to force me to buy them. He’s long just like last time because he’s buying the right to do this; he’s paying me in advance. I’m short because I’m selling him the right to do this. It’s just a different kind of option contract.

“See,” he continued, “Lon thinks the stock is going to move like this.” Shorty took a piece of scrap paper and sketched a quick graph. “The solid line represents his expectation. The dotted line represents mine.” (See Figure 16.1.)

REWARD

“Because Lon thinks Nextall’s stock price is going to fall like this, he wants insurance against it. At a minimum he wants to be able to sell his shares for $35 no matter what they happen to be selling for on the market, whether $25 or $20 or even $5.

FIGURE 16.1 ...