Who is the counterparty to these trades? When the market sentiment is negative, the number of these counterparties are narrow and dwindling, surely it's not that easy to find people who will buy a thing for $5? Maybe they would buy at $4.25 or even less?
Good job asking from the other perspective. Here it is (over simplified to state a point, you would need to do more research).
Let's say Tesla stocks are at 700. If someone offered 2k in addition to the opportunity to buy tesla at $620 / share, I'm sure many people will be lined up to buy it. Not only do you get $2000 immediately in the bank, you also get to buy tesla stock at a 10% discount. Not a bad deal.
> When the market sentiment is negative, the number of these counterparties are narrow and dwindling
That's why his $2600 initial investment made in a much calmer market is now worth $310k :)
For the right price you'll find somebody willing to sell you the insurance you seek. But in a volatile market like today, that price may be way too much for most people.
The counter party is set when you sell the put contract. When you set up a put contract, your broker will find a counter party (or none at all). To incetivice the counter party you pay them a premium, which they get to keep no matter what happens. Once you have the contract, it’s locked in and you have the party. That’s why you set up puts _before_ the general sentiment is that the market will go down.
And since a put is an agreement to sell at a certain price, how can you even sell such an agreement if it’s value has skyrocketed beyond the value of the underlying stock? Certainly the counter party would like to buy the put and let it expire (so they don’t have to pay 620 for a stock trading at 400) but how can the value of the put exceed 620-400? If I paid so much more for a put I would lose the amount that exceeds 620-400 (the amount I would gain)
Imagine it as a bet with a friend.
You: "hey, I got this item worth 10 but I believe it will go down in the next five days."
Friend: "no way."
"want to bet? You will buy it from me for 10 whenever I want to sell it."
"nah."
"I will give you 2 to keep right now!"
"alright."
Your friend has no say when or if you sell. He got paid and hopes you are wrong. Your friend will obviously not agree to pay 10 for an item that is already only worth 5. And yes if the item only goes down to 9 you lost 1 on the bet.
Options are worth an intrinsic value (the current stock price vs the strike price of the contract) and an extrinsic value (the implied volatility of the stock).
Large or sudden moves increase the volatility greatly which can result in the extrinsic value being multiples more than the intrinsic, and this is what leads to the wild profit capability of options.
At the same time, without those moves, or the lack of any umoves, that value can also rapidly decrease and leads to those options being quickly worthless.
I don’t mean to be dense but I am still missing something. I appreciate the fact that the counter party is locked in when you buy a ‘put’. But what if the counter party wants to get out of a bad deal and they declare bankruptcy? After all if they have to buy Tesla at 620 (using the example above) and Tesla is trading at 400 that’s a significant loss.
The person who sold the put to you can short some shares and lend out some money to create a "replicating portfolio" that inversely mirrors the payoff of the put option they sold you. They're making a small % on selling the put and then immunising themselves from the market movements.
Who lent them the stock to short? Index funds! The people who want to make market returns, still do. Everyone is happy
Typically, the other party is required to hold a margin account. If you sell a put for 100 units at $50, and the spot (current) price is $45, you're ($50-$45)*100 = $500 in the red. Your broker requires you in that situation to hold at least $500 (usually more) in cash (or cash-equivalent securities) in your margin account.
If the price dips even more, your broker will ask you to add more money to your margin account quickly, or they will liquidate your position. That means that when you don't keep enough cash to cover the loss, your broker will use the cash in your account to buy a put at $50, effectively zeroing out your position. You lose the money you had in margin account, but you are no longer losing (or gaining) money on market movements.
Traders selling options need either cash or margin to cover the trade (according to various calculations, not always the whole amount).
Their broker also monitors the risk and will liquidate any position if they feel it's too risky, and they have their own funds and insurance to cover trades.
Also the options exchange itself has funds and insurance to guarantee the contracts. There's enough money and liquidity in the overall market that it's extremely unlikely for you to worry about this counterparty risk.
It's more of a concern if you're a major investment fund making 9 figure moves and want to make sure banks remain solvent.
That's thinking really far, good stuff. The trading company (Ameritrade for example) insures up to a certain point. Ameritrade wouldn't let you make that trade if you don't have enough capital to back that trade. Lets say you somehow managed to do that trade, and you declare bankruptcy. I think then Ameritrade would have to cover that cost. Then if they can't, then Ameritrade declares bankruptcy. That's as far as I reasoned.
Put options writers need to post cash collateral to cover their obligations or go on equivalent margin (which will be monitored and enforced by their broker) in order to sell you a put.
If this fails, there's still Options Clearing Corporation managing $120B+ collateral and acting as ultimate guarantor for option contracts.
The bulk of that profit came from volatility spike, rather than simple directional price difference between strike and underlying ("delta").
VIX (https://finance.yahoo.com/quote/%5EVIX) was at 14-15 just a month ago and now at 65 - one of the highest ever! What a time to be alive after years of suppressed volatility!
Both calls and puts increase in value when volatility increases.
When market crashes, volatility shoots up through the roof and significantly increases value even for such deep out-of-the-money options, by far more than the difference between strike and underlying price. Essentially he made most of that money on volatility spike.
