ETF Options 101: 3 Ways To Short SPY

September 25, 2015

ETF investors like to use options because they allow traders to create payoff profiles that can’t be constructed any other way.

For example, without options, there’s only one way to profit from a decline in the price of an ETF: shorting the shares. With options, there are many ways to profit from a decline in an ETF, and based on your outlook, you can craft the trade that precisely matches your point of view.

Options also allow a bearish investor to limit the potential loss; simply shorting ETF shares generates potential losses that are theoretically infinite since the price of the shares can continue to appreciate.

Vertical Call Spreads
As an example, a bearish investor might buy a put option. That put option will require paying a premium, but that premium is the maximum potential loss from the trade.

A bearish investor might sell a naked call, but since selling a naked call generates the same theoretically unlimited loss as shorting shares, we’ll look at our bearish investor selling a call spread, sometimes called a “vertical” call spread.

Selling a call spread will be profitable if the underlying moves down or sideways, while limiting risk. And finally, a really creative bearish investor might combine the two trades by selling a call spread and using the proceeds to buy a put.

Each strategy is bearish, but one costs money to execute, one generates premium that is ours to keep and the last can be done while paying much less net premium.

Value Erosion
An investor who is bearish on the SPDR S&P 500 ETF (SPY | A-99 ) could simply buy a put option and get bearish exposure to the S&P. The put would likely increase in value as SPY falls, but owning a put means we’re fighting the erosion of the value of the put option as time passes. Not only does a put buyer have to pay the premium, but they can be right as to the general direction of the market, down, and still lose money if the market doesn’t drop enough.

For example, with SPY at $192.90 recently, our bearish trader could have bought the November 190 strike put at $5.10. As with any option or option spread purchase, the premium paid—$5.10 in this case—is the maximum loss.

Buying this put gives our investor the right, but not the obligation, to sell 100 shares of SPY at $190 per share any time before the option expires on Nov. 20.

Correct Call, But A Loser
How might this trade lose money even if our investor’s thesis—that SPY is going to drop—is correct? If SPY were to fall to $190.25 at option expiration, the option would be worthless. No one would elect to exercise this option and sell 100 shares of SPY at $190.00 if they could simply sell the shares at $190.25 in the market.

With SPY at $190.25 at expiration, the loss would be equal to the $5.10 paid for the option even though SPY had fallen by $2.65. In fact, our trader will lose the entire $5.10 paid with SPY as low as $190.00 at expiration.

As you can see, while the maximum loss is just $5.10, the trade-off for limiting the loss is that SPY must fall substantially for our put purchase to be profitable.

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