Roquan Smith and a Put Option Enter a Bar
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Roquan Smith, a linebacker for the Baltimore Ravens and formerly for the Chicago Bears, is largely considered one of the best linebackers in the entire NFL. He was named second team All-Pro for the Bears last year and was fifth in the NFL in tackles at 163, nearly 10 a game. With anything in life, if you are one of the best in the world at what you do you would like your compensation to reflect that. The Bears and Smith were at an impasse as the Bears didn’t share the same thoughts as Roquan. Let’s take a deep dive into the situation:
After the 2021 season, the Bears exercised the fifth-year option on Smith’s contract, which guaranteed a salary of $9.7 million for the 2022 season.
Naturally, Roquan Smith wanted a contract that would pay a higher yearly salary when some of the best linebackers in the league make $15-$18 million a year.
The two sides struggled to reach an agreement that would satisfy both sides by the time training camp and preseason games started.
Smith then asked to be traded after talks broke down regarding the contract extension.
The Bears did not grant Smith the permission to seek a trade.
Due to the collective bargaining agreement and Smith’s current contract, Smith was subject to a $40,000 fine for every practice he missed during training camp moving forward, not exactly light.
Smith reported to training camp but refused to practice, as a result.
PUT OPTIONS
Okay, now that we understand Roquan Smith is a good linebacker and the Bears didn’t want to pay him, what does this have to do with a put option? Before we get too far in the weeds, let’s review a put option.
A put option, or simply a put, is a contract that lets the owner sell 100 shares of an underlying asset at a predetermined price on or before the expiration date.
The predetermined price is known as the strike price and the expiration date is set upon entering the trade.
The owner of the put option has the right, but not the obligation, to sell the underlying asset, often a stock, at a specified price, the strike price, within a time frame.
The time frame is defined by anytime before or on the expiration date.
Buying a put option is a bearish assumption as you are expecting the stock to go down and as the price of the asset goes down, the value of the put goes up. Money is made if the option price of the put is worth more than the cost upfront to purchase the asset at its current price.
For example, you purchase a put at $280 and the asset currently trades for $270 your put would be valuable!
The reverse occurs for being on the sell side of a put option. If the asset rises in value, the put value decreases which favors a short position.
A put seller wants the stock price to remain above the strike price. Exact opposite of the $280/$270 example mentioned above.
THEY ENTER THE BAR, NOW WHAT?
We are now well versed in the put option world as well as the Roquan Smith and Chicago Bears verse, exciting times. The Chicago Bears are best viewed as the buy side of the put option and Roquan smith is the sell side.
Buy-side: The Bears have a bearish assumption on Roquan Smith. When setting up the contract, they believed that there was a chance he could miss camp or the preseason for a multitude of reasons and wanted to have something to disincentive the player, thus the $40,000 fine for every missed practice. The Bears have the right, but not the obligation, to $40,000 for each missed practice. However, if he doesn’t miss practice, nothing happens other than the Bears missing out on the potential fines.
Sell side: Roquan Smith is the sell side as he is expected to deliver the money if a practice is missed. Similar to an options trade, with these disincentives, there is a defined period of time in which the fines apply. The Chicago Bears will lay out a period of time, training camp in this case, he can be subject to a fine. Therefore, the end of training camp would be the expiration date. So the Chicago Bears have the right, but not the obligation, to $40,000 per missed practice and if he misses time before the expiration date they will get financially rewarded.
Comparing this to the stock world, let’s say we have a bearish assumption in Netflix (NFLX):
We think the price of NFLX is going to drop substantially from the current price of $330 and want to buy a put option in Netflix.
In this case, we are the Chicago Bears in the previous example. Like da Bears, as a buyer of the option, we have the right, but not the obligation, to exercise the put and sell shares of the stock.
For example, to put that bearish assumption to work we want to buy 1 contract of the $280 put option on the January 20th, 2022 expiration. As a missed practice was the strike price for the Chicago Bears; 280 is the strike price for our put option in Netflix.
As training camp end was the expiration date for the Bears, January 20th is the expiration date for our option.
To break down the specifics of the trade further, 1 contract gives 100 shares of the stock. So we now have the right to sell 100 Netflix shares for $280 each up until January 20th.
Now let's take a step into the future and see how that trade may play out.
In our hypothetical situation, Netflix stock closed at $270. As the holder of one contract of the 280 put option, we hope the stock falls below our strike price of $280 and beyond. Anything below $280 would represent a potential payout. Similar to the Bears receiving $40,000 for anything above their strike price of one missed practice. Time has passed and Netflix is trading for $270 as we get closer to our January 20th expiration. We decide to exercise our put option at this point.
Now, we can sell the 100 shares for $270 and we see a nice return of $1,000. In order to reach that return, we take the $270 it is currently trading at and subtract it from the $280 we bought our option at for a total of $10. Since we have one contract, which represents 100 shares, we take the 100 shares and multiply it by the $10 depreciation to reach $1,000.
NO FREE DRINKS AT THE BAR
However, with anything in life, the cost of doing business is not free. You simply cannot enter these trades for free!
Let’s start with the Chicago Bears. They enter into the contract with Roquan Smith and they have the $40,000 fine for every missed practice present but they are not just entering into this contract with the expectation all Roquan Smith has to do is go out and practice. They must pay him a salary, provide incentives for good play, pay for strength/conditioning/physical therapy for him, and more. Similar to the Chicago Bears paying Roquan Smith, we must pay a premium to the seller.
Similarities exist between the Chicago Bears paying Roquan Smith a yearly salary and what we have to pay the seller of the option.
As a buyer of the option, we pay a premium of $1 per share so they will want to enter the transaction as well.
Just like an incentive must exist for Roquan Smith to enter into a contract with the Bears, thus the yearly salary of a couple million.
In the end, we take the $1 of premium we paid per share and times it by the 1 contract we have, which represents 100 shares, to get a cost of $100 paid to the seller.
When incorporating our cost, we now have a nice profit of $900, the $1,000 made in the decrease in the value of Netflix's stock to $270 minus the $100 in premium we paid to the seller.
Who knew Roquan Smith and a put option entering a bar could be so entertaining.