Huh?

That's been the nature of most options questions in the past few weeks, so this column will address some understandable confusion on several topics: an odd discount on in-the-money options, broker policies on shorting stocks and how to read options trades for sentiment.

Keep those questions rolling in to

optionsforum@thestreet.com, and please include your full name.

European Discount

A recent

story about

Goldman Sachs

buying a 20,000-contract put option on July 10,700 at an average price of 2 1/2 ($250 per contract) left one reader confused about the price.

The Dow closed at 10,534. How could something so in the money be so cheap? Maybe I am missing something here. -- Greg Ray

Greg,

Goldman Sachs bought European exercise options. "Because they're European, they tend to trade at a discount," says Stew Winner,

Prudential's

head of options trading.

European exercise means an option may only be exercised on its expiration day. American exercise means an option may be exercised any time. In-the-money European put options, for example, will be cheaper than their American counterparts because an arbitrageur would have to carry the position all the way to expiration. He or she couldn't exercise the puts and liquidate immediately. Deeply in-the-money European puts can even trade at a discount -- hence the cheap price.

"This purchase probably was an insurance policy," Winner went on to say. "A lot of people purchase these as an insurance policy in case the

Fed

wants to do something radical" with interest rates. The higher short-term interest rates are, the deeper the discount can be.

Next, a well-deserved zinger from the peanut gallery.

Bullish or Bearish?

Your story on the discrepancy in mirror OEX options pricing doesn't make sense. If the out-of-the-money puts are priced three times the out-of-the-money calls, that smacks of bearishness, not bullishness. Ron George of Sorrentino Asset Management does a lousy job of explaining why more expensive put options means people are too bullish. -- James Fink

OK, we should have pressed him on the point. So, let's plunge in. Why are more expensive put options a sign that sophisticated investors are bullish?

We went back to Sorrentino Asset Management and consulted Ron's partner and hedge fund founder Rob Sorrentino. "There are a lot of interpretations as to why puts trade higher than calls," he explains. But, in essence, reading the sentiment tea leaves requires two steps.

In general, puts always have more "premium," which translates into higher prices, than calls do. That's explained, in part, by the market's natural optimism. For instance, with the

S&P 500

index at 1415, a July 1440 call trades at a price of 20 ($2,000 per contract). The 1390 put is trading around 23 ($2,300 per contract). Bottom line: Volatility is greater when the market goes down. "What Ron addressed was that people are willing to pay more for protection against that," i.e. investing in puts, says Rob Sorrentino.

Why is that a signal of bullishness? Sorrentino & Co. are contrarians, moving against the herd. Sorrentino points out that somebody -- mostly hedge funds and investors like him -- has to be willing to sell those options to the people who want to buy. "If people are willing to sell the calls and buy puts, the marketplace is thinking bearish. They think the market's in trouble, and therefore they're willing to pay for those puts, on its face a signal of bearishness. Right now, if they're willing to sell calls for $1 and buy puts for $6, investors are bearish," he says.

"If most of the people are buying puts heavily, I want to sell them. I want to be on the opposite side of what most people are doing. If everybody's buying puts, and most people are wrong most of the time, then to my mind, the market's going through the roof. To my mind, that's a bullish sign. To the crowd it's bearish, but to us, it's the opposite."

Brokers' Shorting Policies

I have shorted a few hundred shares of highflying stocks and covered them for a quick 3- to 4-point gain in the past. But I had all those shorts without any "protection." Now I am considering shorting some of the Internet blue-chips and communication equipment darlings after Aug. 30, once the earnings lovefest is over. Given how these stocks can spike up, I was thinking of buying slightly out-of-money calls before shorting the stock. However, I called Fidelity and asked them: if they were going to "buy in" stock that I was short, would they provide me a chance to exercise call options so I could cover the short? The answer I got from them was NO. This was a surprise for me. Aren't brokers required to notify you if they are going to buy the stock to cover? -- Subodh Nijsure

There are lots of surprises with options. Thank heavens the Options Forum comes to the rescue. Just kidding.

Anyway, this investor wants to short some shares and write out-of-the-money calls to hedge that position. We consulted Dave Gray of the

Chicago Board Options Exchange

to suss out why the brokerage wouldn't allow that.

"The first problem is this: He's invested in out-of-the-money calls, and even though the brokerage could close out the position, it probably wouldn't be enough to cover the short. The short stock position is likely going to be worth more than that," says Gray.

"Let's assume, for now, that this is a $50 stock he's shorted. If he buys the August 55 call, those are out-of-the-money calls. You can't exercise the out-of-the money call until it's in the money."

In the money is a term describing any option that has intrinsic value. A call option is in the money if the underlying stock is higher than the strike price of the call, according to the ever-helpful book,

Options As a Strategic Investment

, by Lawrence McMillan.

Gray continues: "But what he could do is sell the calls to close out the position and capture any premium. He probably paid at least 5 to open it. But now he's got a loss if he sells when the stock goes to 55. That's because with time premium eroded or running out, the option premium will be less. And it likely won't be enough to offset the short position."

The main reason the broker won't allow it? Too risky. "The two positions aren't offsetting, and that's why the broker won't allow it. It's not a covering position. He's simply long an out-of-the-money call and short the stock."

As for Fidelity's policies on individual investors shorting stocks, give them a ring, he advises.

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.

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