Yet, credit is not so simple. Unsecured credit is more akin to being short a put on the assets of the company and long a put with a strike of all debt senior to it. This is a bit complicated, so let’s look at the balance sheet below (Figure 5).
The owner of the unsecured bonds (Jr. Debt) is short a put option at $80 of EV and long a second put option at $10 of EV. Let’s first go through the situational payoffs for the junior debt and then illustrate the payoff diagram.
Below, I’ve illustrated the payoff from the long unsecured bond position (Figure 6). For simplicity, I’ve assumed the $10 coupon is always paid. Changing this assumption would just lead to a kink in the payoff diagram. I’ve also illustrated the payoff from the long put position struck at the level of senior debt (Figure 7) and the short put position struck at the level of unsecured debt (Figure 8). By summing up the two put positions, you can arrive at the long unsecured bond position—implying the bond is simply a put spread on EV.
This now brings up interesting implications. In the last piece, when I simplified debt to simply selling a put option on the assets of the company the delta was easy to calculate. The delta was always positive and higher for lower asset values than higher asset values. Now, however, we have two puts—one short and one long. The delta of the total position is the sum of the individual deltas. Let’s imagine company ABC grows and now has the balance sheet shown in Figure 9.
First, some basic options theory. We’ve already touched on a lot of this, but repeating it should be helpful for those new to options. Deltas are often proxies for the probability an option expires ITM.
Ok, so the lower the EV, the more ITM both put options become. The sold put will always be more ITM than the bought put. The higher the EV, the more OTM both puts become. As the EV increases, the delta of both puts approaches 0. As the EV falls, the delta of the sold put approaches 1, while the delta of the bought put also approaches -1 but is always below the delta of the sold put (in absolute value). A graph of both puts is shown below (Figure 10). The long bond position has a net delta equal to the sum of both options. This graph is shown below as well (Figure 11). When the EV is between the strike of both puts, the delta is greatest. Thus, at around these points the bond position becomes most sensitive to changes in the underlying asset value.
Between the strike of both puts the bond position has the highest delta. This is also where the unsecured bond is considered “distressed.” Thus, the bond becomes to have “equity-like” characteristics (high delta) when it becomes more distressed. Equity generally has high delta when the company is solvent. The chart below should illustrate why the distressed bond appears “equity-like” (Figure 12). When the company becomes insolvent, the delta of the bond position is actually above the delta of the equity position!
Ok, so when a bond is distressed, the delta makes it act “equity-like.” But, bond holders must always hate volatility, right? Nope. In last week’s piece, when I simplified bonds as short put options, the bond was always short vega—its value decreased as implied volatility increased. However, we now have two options, one short and one long. The long option will always be positive vega while the short option will always be negative vega. The combined vega position of the bond is simply the sum of the two vegas. First, some basic vega theory. I am linking last week’s code sample so the reader can try out the vega assumptions (change implied volatility and see how the option price changes depending on whether the option is OTM, ITM, or ATM).
Ok, so the closer the option is to ATM, the higher the vega while the further away, the lower the vega. This makes the bond position (short a put spread) very interesting! Unlike the delta of the position, the vega of the position can theoretically “flip” from negative to positive as the bond declines in value. The vega of both put options are shown below (Figure 13). I’ve also included the combined vega of the position (Figure 14).
This is extremely interesting (to me)! Past a certain point, the long bond position actually moves from short vol to long vol. While investment grade credit investors are undoubtedly short vol (right hand side of the graph), distressed debt investors are often long vol (left hand side of the graph). First, it may be helpful to justify this more explicitly.
The implications are profound. Rather than trying to minimize volatility of the EV, distressed credit investors should seek to maximize volatility as they are long vega. They should pursue turnaround strategies that seek to maximize uncertainty. The distressed debt investor has a positive delta and a positive vega, very similar to a call option on the underlying! Thus, for certain sections of EV, distressed creditors’ forecasts—and goals—should almost match that of the owner of a call option on the EV (Figure 15).
In this piece I have hopefully expanded on the idea that credit can be modeled using options theory. Rather than simply being short a put option on EV, unsecured creditors are, in effect, short one put option and long another. They are far more similar to sellers of put spreads than sellers of puts. Here are some key takeaways from this result.
Thank you for reading until the end. Feel free to reach out if you have any questions or ideas on potential distressed scenarios to apply this framework to (either sovereign or corporate).
Ever wondered if those fancy options trades could leave you broke and owing money? I’ve spent years in the trading world, and lemme tell you – the answer ain’t as simple as most “experts” make it sound.
Options trading can be like playing with fire while wearing a gasoline-soaked suit. One wrong move, and boom – you’re not just broke, but potentially in serious debt. But don’t panic yet! Understanding the risks is half the battle won.
What Are Options Anyway?
Before we dive into the debt question, let’s break down what options actually are for those who might be new to this whole thing
Options are contracts that give you the right (but not obligation) to buy or sell an asset at a specific price within a certain timeframe. There’s two main types:
- Call Options: The right to buy an asset at a set price
- Buy Options: The right to sell an asset at a set price
These little contracts can be incredibly powerful tools – both for making money AND for losing it.
The Scary Truth: Yes, Options Can Put You in Debt
I’m not gonna sugarcoat this like most financial advisors would. Options trading absolutely CAN put you in debt under certain circumstances. And we’re not talking about small debt – we’re talking potentially life-altering, bankruptcy-level debt.
The main ways this can happen include:
1. Selling Naked Calls: The Unlimited Risk Strategy
When you sell a call option without owning the underlying stock (called selling “naked”), you’re essentially making a bet that the stock price won’t go up. But here’s the terrifying part – if the stock price skyrockets, your potential losses are UNLIMITED.
Let me explain with a real example:
You sell a naked call option on GameStop stock with a strike price of $50, and collect a $200 premium. You’re feeling good about that easy money…until the stock suddenly surges to $400 during that meme stock madness. Now you’re obligated to deliver shares at $50 that cost $400 to buy. That’s a $350 loss PER SHARE, potentially tens of thousands in debt instantly!
2. Margin Calls: When Your Broker Demands More Money
When trading options, many brokers let you use “margin” – essentially borrowing money to make bigger trades. Sounds great until the market moves against you and your broker sends a “margin call” demanding more cash ASAP.
If you can’t pay up, they’ll liquidate your positions (often at the worst possible time), and you’ll still owe any remaining balance.
3. Assignment Risk: When Options Get Exercised Against You
This one catches so many newbies by surprise. If you sell options and the buyer decides to exercise their right, you’re obligated to fulfill that contract regardless of how much it costs you.
For instance, if you sold put options on a stock that suddenly crashes, you might be forced to buy shares at way above market value. Your account balance could go negative real quick.
Who’s Most at Risk of Options Debt?
Not all options strategies carry the same danger level. Here’s who should be extra careful:
- Beginners who don’t fully understand the mechanics
- Traders using high leverage or margin
- Option sellers (especially naked options)
- Anyone trading volatile stocks or during market turbulence
- Emotional traders who can’t stick to risk management
I’ve personally seen plenty of smart people blow up their accounts because they underestimated options risks. One friend lost over $50,000 on Tesla options in a single day – money he definitely didn’t have to lose.
Safer Ways to Trade Options Without Risking Infinite Debt
Don’t worry, it’s not all doom and gloom! There are plenty of ways to trade options with strictly limited risk:
Buying Options Instead of Selling Them
When you BUY calls or puts, your maximum loss is limited to the premium you paid. You can’t lose more than you invested.
Using Defined-Risk Strategies
Strategies like:
- Vertical spreads
- Iron condors
- Butterflies
These all have built-in risk limits by their very structure.
Setting Strict Position Sizing Rules
Never put more than a small percentage (I recommend 1-5%) of your total portfolio into any single options trade.
Real Talk: Horror Stories From the Options Trading Trenches
Let me share some real examples I’ve witnessed of options gone wrong:
“I sold naked puts on a biotech company right before their drug trial failed. Stock dropped 80% overnight. Owed my broker $32,000 I didn’t have. Took me 3 years to pay it off.” – Anonymous trader
“Thought I was being smart with a ‘can’t lose’ iron condor on SPY during what seemed like a calm week. Then COVID hit in March 2020. Wiped out my entire account plus another $15k in margin debt.” – Options trading forum post
These stories aren’t meant to scare you (ok maybe a little), but to show the real consequences when things go wrong.
How Brokers Handle Negative Balances
What actually happens if your account goes negative? It depends on your broker and the situation:
| Broker Action | Likelihood | What It Means For You |
|---|---|---|
| Immediate margin call | High | You must deposit funds within 1-5 days |
| Account liquidation | High | Forced selling at potentially terrible prices |
| Collection attempts | Medium | Calls, emails demanding payment |
| Negotiated settlement | Low-Medium | Potential to settle for less than full amount |
| Legal action | Low-Medium | Lawsuits to recover funds |
| Debt write-off | Very Low | Don’t count on this happening! |
Most reputable brokers will pursue negative balances, and these debts don’t just disappear. They can affect your credit score and financial future.
How to Protect Yourself When Trading Options
Based on years in the markets, here’s my best advice for staying out of options debt:
- Start with paper trading – Practice without real money first
- Get properly educated – Not from TikTok or Reddit, but actual comprehensive courses
- Use risk-defined strategies – Especially as a beginner
- Set hard stop-losses – And actually honor them!
- Only trade with money you can afford to lose – Seriously
- Be extra cautious with margin – Or avoid it completely at first
- Understand assignment risk – Know exactly what happens if assigned
- Have emergency funds – Separate from trading capital
Specific Broker Policies Worth Knowing
Different brokers handle risk differently. Here’s what to look for:
- Risk checks – Some brokers won’t let you place extremely risky trades without experience
- Margin requirements – Higher requirements = less leverage = less debt risk
- Auto-liquidation policies – When and how they’ll close positions
- Assignment handling – How they process and notify about assignments
- Negative balance protection – Some brokers offer limited protection (rare in US)
I personally prefer brokers with stronger risk controls, even if it means slightly less flexibility. The guardrails can save you from yourself.
Common Misconceptions About Options and Debt
Let’s clear up some dangerous myths:
❌ Myth: “I can just ignore margin calls if things go bad”
✓ Reality: Ignoring margin calls leads to forced liquidation and potential legal action
❌ Myth: “Brokers will forgive negative balances if they’re large enough”
✓ Reality: Brokers have legal teams specifically to pursue large debts
❌ Myth: “Options are just like stocks but with more leverage”
✓ Reality: Options have completely different risk profiles and mechanics
❌ Myth: “I can always close positions before assignment”
✓ Reality: Early assignment can happen with no warning, especially around dividends and corporate actions
My Final Thoughts on Options and Debt Risk
After years in the markets, I’ve come to respect options as powerful tools that deserve serious caution. Can options put you in debt? Absolutely, devastatingly so. But that doesn’t mean you should avoid them completely.
It means approaching them with proper education, risk management, and humility. Start small, use defined-risk strategies, and never trade with money you can’t afford to lose.
Options trading isn’t a get-rich-quick scheme – it’s a sophisticated financial tool that can either help build wealth or create financial disaster, depending entirely on how you use it.
Remember, even professional traders blow up accounts sometimes. The difference is they survive to trade another day because they never risked more than they could afford to lose.
Have you had any close calls with options trading? What strategies do you use to manage risk? I’d love to hear your experiences in the comments below.
Happy (and safe) trading!
Equity = Call on EV
It’s worth reviewing the end of last week’s piece where I talked about equity and debt as very similar to options. Owning stock has practically identical payoffs to owning a call option struck at the value of debt. Equity receives all the upside of the value of the company after debt is paid off. Stockholders downside is limited to their equity investment, just like call owners (Figure 1).
Figure 1: Being Long a Company’s Stock has Payoffs Similar to Long a Call Option on EV
The greater the intrinsic value of the equity (more solvent the company/right hand side of the diagram), the more directly the change in underlying asset value is reflected in the change in stock price. This is called the delta of the stock with respect to the EV. This is hard to see in the payoff diagram as the payoff diagram only focuses on the payoff at expiration. As a rule, deltas are ~.50 for ATM calls and increase as the call becomes more ITM. Below is a hypothetical illustration of how much the stock might move for a given change in EV. When the stock is ATM (company is barely solvent), a $1 increase in EV should equate to a ~$.50 increase in equity value. When the stock is very ITM (EV = $1,000), a $1 increase in EV should equate to almost a $1 increase in equity value (Figure 2).
Figure 2: Hypothetical Illustration of the Delta of the Stock wrt EV
Let’s now briefly look at the vega of the stockholder. As a reminder, vega is the sensitivity (derivative) of equity value with respect to changes in volatility of the enterprise value. Last week, I mentioned equity owners are long vega, or benefit from volatility/uncertainty in the assets of the company. The chart below is for illustrative purposes only and not for a specific situation. As you can see, the stock benefits more from increases in volatility the lower the intrinsic value of the stock (up to a point). Vega is highest for ATM options. That is, the closer the stock is to insolvency (debt burden point), the more the stock owner wants volatility. Stocks are almost always long vol, they are just significantly more so when the company is closer to insolvency (Figure 3).
Figure 3: Hypothetical Illustration of the Vega of the Stock wrt EV
Examining debt’s sensitivity to volatility and value from an options trading lens.
Hey everyone, today we are continuing with the theme of the last piece linked here. Please reach out if you have feedback or would like to discuss the ideas further ([email protected]).
Last week, I provided an introduction to the basics of options and options pricing. I then expanded this view to talk about how equity is a quasi-call option on the enterprise value of a company struck at the debt burden. I further mentioned debt could be viewed as selling a quasi put option. Probably more accurately, buying corporate debt is akin to being long a risk-free bond and short a put option on the EV of the business. I will review these points in this piece.
Importantly, I will try to offer a more precise view of credit. Buying debt is not as simple as being short a put option on the EV of a company. Instead, it is more similar to being short a put option on EV at a strike price of the total debt burden and long a second put option struck at all debt senior to it. This is rather complicated and I will try to simplify this throughout the paper. I will then write about the implications of this view on credit investing. Most interesting, the distressed creditor, rather than being short a put option, appears to have a quasi-call option on the company.
The purpose of this paper and the last one are to set up a counterintuitive framework for credit investing. I will then try to apply this framework to explore potential trade ideas in the next piece. The third part of this series will likely take a bit longer to complete, apologies in advance.
- Last Week Review: Equity is a Call, Debt is Short a Put
- Debt is Short a Put and Long a Put!
- Delta of the Bond Holder
- Vega of the Bond Holder
- Conclusion
How Do I Pay Off Debt When I Can’t Afford The Minimum Payments?
FAQ
Can you go negative with options trading?
Can you owe money on an option trade?
You can’t go into debt from buying calls or puts (though you can lose all your money very quickly). You can’t go into debt by selling covered calls or cash-secured puts either.
Can you lose a lot of money with call options?
Can you get into debt from trading?