What it means
A put option gives its holder the right to sell a share at a fixed strike price. When that strike sits far above the current market price, the option is described as deep in-the-money and most of its price is intrinsic value, meaning value the holder would get by exercising it immediately.
Such an option behaves like a short position in the share, falling in value as the share rises and gaining as it falls. The trade exists because short selling has always been the awkward cousin of ordinary dealing.
A short seller must borrow the shares, pay a borrowing fee, post margin and comply with rules that in various markets have restricted when a short can be placed. Buying a deep in-the-money put sidesteps the borrow entirely and the most that can be lost is the premium paid.
The term itself comes from the trading floor and carries the sense of firing a single, direct shot rather than building a position. It is also used more loosely for any trade in a deep in-the-money option bought for immediate directional exposure rather than for the usual reasons people buy options.
In use, the trader works out how much of the option's price is intrinsic value and how much is time value, because the time value is the real cost of the arrangement. A put with a $70 strike on a $40 share holds $30 of intrinsic value, so a price of $31 means the trader is paying just $1 per share for the convenience and the limited downside.
The thinner that time value, the closer the trade tracks a genuine short. The nuance is liquidity.
Deep in-the-money options often trade in small volumes with wide gaps between the buying and selling price, and that spread can cost more than the borrowing fee the trader avoided. Early exercise, dividends on the underlying share and regulatory attitudes to trades that mimic shorting all deserve a check before the order goes in.
In practice
Real-world examples.
Example
A hedge fund analyst is convinced a listed retailer will miss its Christmas numbers, but the shares are expensive to borrow because everyone else thinks so too. He buys deep in-the-money puts instead, accepting a small amount of time value in place of a borrowing fee that was running at 9% a year.
Example
A family office is not permitted by its own investment policy to short shares at all, yet it wants to reduce the risk in a large legacy holding it cannot sell for tax reasons. It buys deep in-the-money puts over part of the position, which offsets most of the downside while the shares stay on the books.
Example
A proprietary trader wants a quick, defined-risk bet against an index after a surprise policy announcement. She buys an in-the-money index put with two weeks to run, knowing the most she can lose is the $12,000 premium even if the market rallies hard against her.
Formula
Calculation
Intrinsic value of a put = strike price - current share price
Time value = option premium - intrinsic value
Profit on the trade = (premium received on sale - premium paid) x shares per contract
Maximum loss = premium paid
Worked example. A share trades at $40 and a trader wants short exposure without borrowing stock. She buys one $70 put, covering 100 shares, for a $31.00 per share premium.
Intrinsic value = $70 - $40 = $30.00 per share
Time value = $31.00 - $30.00 = $1.00 per share, so her total outlay is $3,100 of which $100 is time value.
The share then falls to $30. The put's intrinsic value is now $70 - $30 = $40.00 per share and she sells it for $40.50, keeping $0.50 of time value.
Profit = ($40.50 - $31.00) x 100 = $950
The share itself fell $10, so a true short of 100 shares would have made $1,000 before borrowing costs. The $50 difference is the time value she gave up, and her worst case was always the $3,100 premium.Case study
Seen in the real world.
Here is an illustrative and clearly fictional situation. Alderstone Capital is a small discretionary fund whose mandate forbids borrowing stock, a restriction its founders wrote in after a bad experience years earlier. Its analyst becomes convinced that a listed logistics group trading at $40 has overstated the profitability of a new contract.
Rather than argue for a change to the mandate, the portfolio manager buys 200 deep in-the-money puts at a $70 strike for $31 each, an outlay of $620,000, of which only $20,000 is time value. When the group restates its figures and the shares fall to $29, the puts are sold for $41.25 and the fund books a gain of a little over $200,000.
In the illustrative post-trade review the manager notes the part that nearly went wrong: the first broker quoted a spread wide enough to swallow a quarter of the expected profit, and only a second quote from a market maker in the contract made the trade worth doing.
Watch out
Common mistakes.
- Treating a bullet trade as a free short. The time value paid, the dealing spread and the risk of the option being hard to sell later are all real costs.
- Buying an option that is not deep enough in-the-money, so a large part of the premium is time value and the position tracks the share price poorly.
- Ignoring the possibility of early exercise and the effect of dividends on the underlying share, both of which can change the economics before expiry.
Questions
People also ask.
Why buy a deep in-the-money put rather than short the share?
It avoids borrowing stock and the associated fee, it caps the loss at the premium paid, and it may be permitted where outright shorting is not.
Does a bullet trade behave exactly like a short position?
Very nearly, because a deep in-the-money put has a price sensitivity close to one-for-one with the share, but the small time value and the dealing spread mean it lags slightly.
Is a bullet trade a way around the rules?
No. It is a legitimate options trade, but anyone using it to achieve an outcome their mandate or their regulator restricts should document the reasoning and take compliance advice first.
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