Musing 4 of the Day: I keep hearing the refrain “why not just buy puts” instead of shorting stock outright. In this thread, I am going to explain who takes the other side of your puts and how they hedge.

Imagine a world before liquid options markets existed. This wasn’t too long ago, consider Fischer Black and Myron Scholes didn’t publish their paper until 1973.

A call option represents a right to buy a stock at a strike price K; payoff chart looks like a rightward facing “hockey stick.”

A put option represents a right to sell a stock at a strike price K; payoff chart is the mirror image of a call option — a leftward facing hockey stick.

The fact that options have asymmetric payoffs (curvature in their payoff diagrams) means that they can only be replicated by DYNAMICALLY trading the underlying stock.

The sensitivity of an option to the underlying stock is called the “delta,” which can be simplistically thought of as the first partial derivative of the option price function with respect to the stock if you remember your first year calculus.

When you buy an call option that heretofore has not existed before, the dealer that takes the other side of your trade needs to replicate the trade by dynamically “delta-hedging” with the stock.

So if you buy a call, the dealer is short a call to you and needs buy the “delta-equivalent” amount of shares and keep adjusting this delta as the stock moves.

Conversely, when you buy a put (here is where you need to pay attention), the dealer is short a put to you and needs to dynamically adjust a SHORT STOCK POSITION equivalent to the “delta-equivalent” short exposure of the option.

So what happens if “lynch mob” short attacks make it impossible for dealers to hedge their positions? The entire market mechanism breaks down. At best, market-makers will price options exorbitantly to reflect the heightened risk. At worst, market-makers blow up.

You can now take what I just explained about options hedging and extrapolate it to other markets like convertible bonds and other equity-linked derivatives. Mind you, these are just the markets with EXPLICIT mathematical relationships to the underlying stocks.