The Big Short’s Michael Burry and Understanding Put Options
What movie uses humor to explain a complex topic better than any other film?
I think it’s The Big Short.
Based on a book by Michael Lewis, the movie explains how a small group of investors bet against the US mortgage market in 2006-2007. In their research, they discover how flawed and corrupt the market is, and make huge returns when the market collapses.
One of the investors was a former Doctor named Michael Burry, played by Christain Bale. Burry placed a huge bet that the mortgage market would crash, and he made a personal profit of $100 million and a profit for his remaining investors of more than $700 million.
Well, he’s back.
In August of 2023, Yahoo! Finance reported that Michael Burry bought put options against the SPDR S&P 500 ETF Trust, which tracks the S&P 500, and put options against Invesco QQQ ETF, which tracks the NASDAQ 100.
What does that mean, exactly?
Understanding Exchanged Traded Funds (ETFs)
Investopedia defines an ETF as:
“An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can.”
Wikipedia explains that: “The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.”
OK, so how can you bet on the price of the S&P 500 index going down?
Buy puts on SPDR S&P 500 ETF Trust
Explaining put options
To buy a put option, the investor pays a cost (called a premium) for the right to sell a specific amount of units of the index at a specific price. EFT units are similar to mutual fund shares. As of 8/24/23, an EFT trust unit was trading at a net asset value (NAV) of about $436.
Let’s say you pay a premium for the right to sell 100 units of the trust at $430. $430 is referred to as the strike price (or exercise price). If the value declines to $415, you buy 100 units at $415, exercise your put, and sell the same 100 units at $430. You’ve earned a profit of $15 per unit.
What if the value of an EFT unit increases to $450?
In that case, it doesn’t make sense to exercise the put and sell at $430- you can sell at the market price of $450. The put buyer may let the option contract expire worthless- and simply lose the premium paid for the option.
The put buyer can profit when the price of the underlying investment (the EFT units) declines. Burry is using the same strategy for the Invesco QQQ ETF, which tracks the NASDAQ 100 (another stock index).
One more thing: if you exercise a put and sell the underlying security, you must make delivery of the security to the buyer. If you don’t own the security, the price you may pay is infinite- meaning that the potential loss when you purchase the security is unlimited.
Hence the term “putting it to someone”.
Burry’s strategy works if the ETF units fall in price- and that’s when you exercise the put and sell the units.
Food for thought.