What Is a Put Option? How The Big Short’s Michael Burry Shorted Tesla

Back in 2021, Michael Burry, the investor made famous by “The Big Short” book and film, used put options to take a huge short position against Tesla. What are put options, and how does a trade like Burry’s generate a profit?

The story: Burry’s put options

A 13F filing dated 17th May, 2021, from Scion Asset Management, the private investment firm created and run by Michael Burry, shows that it took out a massive put option position in Tesla (TLSA).

What is it that Burry was trying to do here? In essence, he used the options market to sell Tesla shares short, meaning he positioned his firm to profit when Tesla shares go down in value.

This bearish bet covered over 800,000 TSLA shares. That is a huge trade with a notional equivalent value of over $530 million. At the time, it was his biggest position, taking up 40% of his entire portfolio in nominal terms. If you’re a poker player, you could say he went “all in”.

The filing does not reveal the exact timing of the positions or the strike price or expiry dates, though it discloses that they were executed over a period of three months. Given that Tesla’s stock took a serious downturn during the same time, the position was most likely profitable.

He did reveal in a tweet that he was short in early December, presumably with a smaller position:

“So, @elonmusk, yes, I’m short $TSLA, but some free advice for a good guy … Seriously, issue 25-50% of your shares at the current ridiculous price. That’s not dilution.”

This is merely one example of a trader using put options, millions of which are taken out every day. Our goal in this article is not to analyse Burry’s investment strategy, the reasoning behind this trade, or Tesla’s history – let’s first look at what a put option actually is.

Definition of a put option

Options give an investor the right – but no obligation, unlike futures contracts – to buy or sell a security at a particular price on a specified date. They are derivative instruments that acquire their value from another financial market, typically referred to as “the underlying asset”. The price of the option will change in line with the price of the underlying, which may be stocks, debt securities, commodities, or even indices.

All options have a strike price and an expiry date.

The strike price is the price at which the underlying asset can be bought or sold for if the option is exercised (used).

The expiry date is when the option can be exercised; after this, it’s worthless. Options may expire at the end of the trading day or several months from when the contract is signed.

Options come in two flavours. Though formally similar, the difference arises from how they are used:

A put option is bought when the investor expects the underlying market to go down

A call option is bought when the investor thinks the underlying market will go up.

Of course, buying either kind of option requires a counterparty or seller, called an option writer. These make their money by issuing options based on a conservative view of the market, not by speculating that any given asset will go down or up unexpectedly.

A put-buyer (like Michael Burry) pays a premium for the puts – a kind of transaction fee paid to the option writer. This premium is the most the buyer of a put option can lose from the trade. This aspect of put options limits their risk compared to if they had taken out a naked short position (selling shares they do not own and may not be able to borrow) on the underlying market, which could result in extensive losses.

If the price of the underlying falls below the strike price by an amount that exceeds the amount already paid in premiums, then the holder of a put stands to make a profit on the trade. Otherwise, the put buyer will lose either the full amount or part of the premium paid.

To realise the profit or loss, the holder of a put option can either sell the put on to another trader before it expires, or exercise the option to sell the shares and perhaps buy them back again at the lower market price.

Put options can be in, at, or out of the money:

“In the money” means the underlying asset price is below the agreed-on strike price.
“Out of the money” means the underlying price is above the strike price.
“At the money” means the underlying price and the strike price are the same.

These phrases are also used to describe call options, though the meaning of the first two are reversed.

Theoretical outcomes of Michael Burry’s put option trade

Let’s see how Burry’s bet that Tesla’s stock would go down might have played out. For the sake of argument, we’ll say that Tesla is currently trading for approximately $590 per share.

Our imaginary version of Michael Burry thinks the Tesla share price will be cut in half. This is presumably more aggressive than what he actually did – on the other hand, he did make a name for himself by going massively short on the US housing market, so let’s not rule anything out completely.

Below, an options board similar to what you might find on any online trading platform shows a put option with a $300 strike price and expiry date six months from now:

For the sake of simplicity, we’ll say that the premium paid to the party writing the put option is 10% of the strike price. In other words, puts with a strike price of $300 and expiring in six months are available for a $30 premium per share.

Option contracts are always for lots of one hundred shares, so one put contract costs $3,000 ($30 premium x 100 shares). Note that this amounts to leverage: at today’s stock price, it only costs $3,000 to control a $59,000 position. Also, because one contract represents 100 shares, every $1 decrease in the stock’s market price below the strike price increases the total value of the option by $100.

The breakeven point – the share price below which the option begins to earn a profit, has intrinsic value, or is in the money – occurs at $270. That is the strike price of $300 minus the $30 cost of the put itself.

If TSLA stock trades between $270 and $300, the option will retain some value if sold on the secondary market before it expires, but it does not show a net profit.

If the stock remains above the strike price of $300, the option is out of the money and becomes worthless. So, the option value flatlines, capping the investor’s maximum loss at the price paid for the put, of $30 premium per share or $3000 total.

Getting familiar with put options

Though online trading makes taking out put options simple and your risk is always limited to a finite amount, making these trades should still be approached carefully. Options trading is a zero-sum game, and it’s hard to be consistently smarter or luckier than the market as a whole. It is definitely a good idea to first hone your skills through paper trading using imaginary money.

You’ll find a multitude of different resources to help you on this journey. For example, with a bit of help from an online calculator, we can estimate the possible results of a real Tesla options trade if it were executed at today’s price.

The potential profit/loss at various prices and dates then looks as follows:

Working through these various scenarios and evaluating the likelihood of each will help you determine a sensible risk management strategy and position sizing…probably less extreme than that of Michael Burry in 2021!