Smarter Money: A Puts Primer, Part 2

Editor's note: This is the second installment in a two-part article. Be sure to check out Part 1!

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Now, let's say that you are an institution and you want thousands of puts because it simply doesn't help you to have less. You can't make enough money. You want to make a big bet against the Cramer Tech Wreck index.

Do you think you can go in and buy 1,000 puts the same way you buy 10 puts? Absolutely not. And this is where the market impact comes in. You need help to get that trade done.

You need "help." I put quotes around the word "help" because that is actually a term of art in this business. It is also known as "facilitation." You need a brokerage house to manufacture that put for you in size. The exchange where the index might be located will make a decent market in the Cramer Tech Wreck index for only about 100 puts. Once that level is exceeded, you are on your own.

Being on your own means that you need to ask the derivatives (options are derivatives of common ) to make you an offering. The desk has to go take on some risk and position you so that you get your sizable puts and they get their sizable positions.

Here's the rub, though. You are making a bet laden with risk. You will be risking millions of dollars to buy that put. If the Cramer Tech Wreck index goes up and up and up after you buy that put, you are going to be out all of your money.

How do you think that the brokerage house sells you that put? Why, he hedges. He sells the underlying stocks in the actual index at a ratio with your buy of puts. So if you buy a thousand puts he might have to be short thousands of shares of the individual stocks in the index. He can't risk just selling you the put without being protected, because if the Cramer Tech Wreck index gets cut in half, he will lose a ton of money. He is short the put, which is the same as being long the index!

He doesn't want to be long an index. He doesn't want to be short it either. He just wants to help you. He just wants to facilitate you and get the commission. So he lays off the risk and shorts the stocks "underneath" that are in the index. He tries to be "neutral."

When he does that though -- when he sets up his position -- he winds up being short a huge number of stocks as part of his business of being short that put to you.

OK, now the index goes down a tad. Not a lot but a tad. And you decide that is all of the money you are going to make. So you try to sell the put. When you do, the same firm that bought you the put is anxious for you to come back to sell the put. That allows the brokerage firm to close out the position. He is still short the stocks to you and short the put to you.

When you sell the put, he buys it back and covers the stocks. It is that last bit, WHEN HE BUYS THE STOCKS BACK, that can often cause the index to move up. That's the action that makes selling a put bullish. When the broker goes in to buy all of the stock back it looks like a giant wave of buying. And it can cause a vicious upswing, depending upon how it is done.

That's why, when I say, "I see a lot of put-selling," it is bullish. Not bearish. Institutional put-selling means brokerage houses are going to buy back the stocks they are short from when they sold you the put to facilitate the trade.

That's why the answer to the question at the beginning of this piece is b. When you hear or when I write "seller of puts" what I mean is that a large institution that had bought a ton of puts on an index is now taking that trade off and the broker will have to unwind the position. That will cause a momentary upward move as the stocks are bought back simultaneously with the selling of the put.

Hence the bullish nature of the move.

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