Basically, a put option is like a bond, and a Default Swap is a bet that debt will not default. If we treat her allowance as “defaulting” if she doesn’t get her allowance, then a default swap would be a situation in which she’d pay a fee to a third party, and if she doesn’t get her allowance, the third party would pay it to her.

A “Reverse Default Swap” is the inverse, and it is basically the third party paying her a fee so that, if she doesn’t get her allowance, she would have to pay the amount of the allowance to the third party. Normally, this is meant to undo a previous Default Swap.

A put option is a contract in which an issuer issues to a second party the right to sell an asset as a specified price at a specified time. The agreed upon price is called the “Strike Price”, and the agreed time is the “maturity”.
Now, the issuer is betting that the price of the asset will be higher than the Strike Price when it matures, rendering the option worthless and thus the issuer has made the value of the premium at no cost to himself.
The buyer of the put, by contrast, is betting that the value of the asset will be less than the Strike Price when it matures, at which point he can buy the asset and then sell it at the Strike Price, pocketing the difference.
As such, the buyer of the put is (counter-intuitively) in the short position on the asset, because the more it falls in value, the more money he makes. The Issuer is in the long position, as he wants the asset to grow in value.

So, putting it all together, Sandra is doing a Reverse Default Swap on her allowance, which means that if she doesn’t get her allowance, she has to pay a third party. Therefore, the Reverse Default Swap is an asset that has more value if she does not get her allowance, because the buyer of the Swap gets money if there is a default. She is then issuing put options on the Reverse Default Swaps, and all the people who buy said put options are now betting that the Reverse Default Swap is going to go down in value so that they can then buy low and sell high when the put option matures.

Then SANDRA starts short-selling the put options, thereby betting against the people who bought the options, who are betting against the people who bought the Reverse Swap, who are betting against her getting her allowance. As such, if she doesn’t get her allowance, the people who bought the Reverse Swap make money, causing the people who bought the options to lose money, which in turn causes Sandra to make a fortune on the short-selling.

I @ Axalto:
I agree. I have absolutely NO IDEA WHATSOEVER what she just said. Then again, I STILL don’t understand government, despite being a senior in high school, I STILL have a hard time understanding Finacial Lit, even though I took the class last school year, and I STILL have almost NEVER understood stock.

Haha!… wait… what?

Ok, that one was interesting too. Especially with it coming at the time of all those hedge funds and their naked short selling. Well, that was a few months earlier, really. No, the real way to sucker them would have been to buy up all the far out of the money call options in something they were naked shorting for next to nothing, then buy a bunch of stock, and then demand delivery of stock certificates, and then redeem your options for more shares and demand delivery. That would take a lot of money to do, but it would drain them dry, oh yes it would.

Keep up the good work, another informative post.