For Europe Bears, Some IEV Options Trades

January 15, 2015

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options. Almost 136 million options on ETFs were traded in December 2014, and because ETFs and options are among the fastest-growing financial vehicles in the world, it only makes sense to combine the two. This column highlights unusually large or interesting ETF options trades to help readers understand where traders believe a particular ETF may be headed. In doing so, Nations will examine the underlying options strategy.

 

The iShares Europe ETF (IEV | B-96) is a fairly modest ETF given that it seeks to represent nearly all European stocks.  It tracks the S&P Europe 350 Index which is comprised of 350 blue-chip companies selected from 16 developed European markets.

It’s not the biggest European ETF and with just $2.57 billion under management. And lately, it’s an ETF that has much to be modest about. Its 52-week performance hasn’t been particularly impressive either as it has lost just over 8 percent as of Tuesday’s close.

 

I’m getting to a trade using IEV options, but let’s look how rough the going has been for IEV and a number of other Europe-focused ETFs. 

 

As I said above, none of the European ETFs have done very well over the past year as Europe itself has struggled with inherent political struggles regarding the right economic policies.  

 

 

IEV hasn’t been the best performer from Europe and it hasn’t been the worst.  But one trader thinks things are going to get much worse for IEV and has been thinking that for some time and he’s making an outsized bet given IEV’s assets.

 

IEV Option Trade Setup

In December, one trader bought 15,000 IEV put spreads expiring in March, and another 9,000 similar put spreads expiring in February were bought on Tuesday.

Yesterday’s trader began with a buy of 9,000 of the 41 strike IEV puts expiring in February.  He paid $0.90. To reduce that cost just a little he sold 9,000 of the 36 strike puts expiring in February.  He received $0.05. 

He paid a net of $0.85 per share or a total of $765,000.  At expiration he will profit if IEV is below $40.15, but his profits are limited by the fact that he sold those 36 strike puts; his maximum profit per share is $5.00. The width of the put spread, minus the $0.85 cost, or $4.15, and he’ll realize that with IEV trading at or below $36.00 at February expiration. His total potential profit is $3.735 million.

You can see the payoff profile for this option trade.

 

 

A Few More Options Trades

In December one trader bought 15,000 of the 36/39 put spreads expiring in March.  On Tuesday, a trader—maybe the same trader and maybe a different one—bought 9,000 of the 36/41 put spreads expiring in February.  If it was the same trader, he’s now long 24,000 put spreads which corresponds to 2.4 million shares of IEV, about 4 percent of the ETF’s shares outstanding, worth nearly $100 million.

There’s nothing wrong with a trader taking an outsized position if it’s an effort to hedge risk or if he has conviction in his speculation. 

But such a large position means that with IEV near those strike prices at expiration the ETF is going to be volatile, maybe extremely volatile. After all, traders with positions in those expiring options may trade IEV to hedge their options and their trades in the options themselves in an effort to exit positions will lift volatility too.

There’s plenty of academic evidence as well as anecdotal instances showing that an ETF will get pulled to strike prices with the largest open interest as expiration nears.  This is caused by professional option traders “delta hedging” in the underlying ETF to wring the directionality out of their option trade and make it a purely volatility-based trade.   

 

Close Your Eyes

This will be one of those times when a long-term investor should close his eyes to the short-term gyrations of the ETF price.  It will also be one of those times when active ETF traders will be working IEV hard to generate short-term profits. 

But be careful, with an option position that large it will be “adult swim” time.

 

At the time this article was written, the author had no positions in the ETFs mentioned. Follow Scott on Twitter @ScottNations.

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