Inside The World Of SPY Options Trading

January 22, 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.


ETFs and options on ETFs are wonderful tools for active traders. ETFs have made asset classes that weren’t previously available to traders just a mouse click away. Also, the growth in options trading and options education means that more and more traders take advantage of the nearly infinite number of strategies options can offer.


In the 1980s, retail traders could only read about the high-yield debt market. Now there are more than a dozen high-yield debt ETFs, many with very liquid option markets.


The same was true for international equities. Traditional mutual funds existed, but they were subject to style and geography diffusion, and if you thought one of those markets was going to go sideways, there was no options market that would allow you to execute a strategy to take advantage of that.


But option traders are better off today, even in those underlying indexes that were available before the advent of ETFs and options on those ETFs. 


Liquid SPY Options Market

For example, options on the SPDR S&P 500 ETF (SPY | A-98) didn’t launch until 2005, and options on the S&P have been available since the 1980s, but every options trader in the world is now able to take advantage of S&P option markets with a bid/ask spread that is only $0.01 wide. Before options on SPY launched, those bid/ask spreads were much wider.


This liquidity means that multileg spreads and combinations allow a trader to make a defined-risk trade that SPY will go up, down or sideways. And one institutional trader did just that in SPY on Tuesday.


SPY has traded in a relatively narrow range—narrow being a relative term—since the beginning of the year as you can see.



It might seem that SPY has bounced around during the first 12 trading days of 2015, but since SPY was launched in 1993, the average range for SPY over the first 12 trading days of the year is 5.25 percent, while in 2015, it was just 4.1 percent.


If a trader thought that sideways price action would continue with the possibility that SPY would resume its march higher, there are several option strategies she might use to profit. But one of those strategies has the advantage of making money if SPY does nothing, moves higher or even if it moves a little lower and does so while limiting risk. 


So what is this wonderful trade that limits risk but generates return given a variety of outcomes? Selling a put spread.





Anatomy Of An Options Trade

On Tuesday, one institutional options trader sold a bunch of put spreads on SPY. 


He sold a total of 17,229 of the SPY 200 strike puts expiring in February and bought the same number of SPY 195 strike puts expring at the same time in order to limit his risk. While our trader executed his trade in three big “chunks” just a few moments apart, and with slightly different prices for each group, the prices he got for the first group are illustrative of the payoff and risk for the trade.


He sold the 200 strike puts at $3.64 per share with SPY at $201.63. Since each option corresponds to 100 shares of SPY, he collected a total of $6.27 million for selling these puts. By selling them, he has committed himself to buying 1.72 million shares of SPY at $200.00 per share if the owner of these puts elects to exercise them, which that owner will do if SPY is below $200.00 at February expiration. Our put seller can only profit by the $6.27 million collected, but has nearly unlimited risk since SPY could drop well below $200.00 by February expiration.


To limit that risk, our option trader paid $2.28 for the 195 strike puts, meaning he paid a total of $3.93 million, so he now has the right, but not the obligation, to sell 1.72 million shares of SPY at $195.00, which he will do if SPY is below $195.00 at February expiration. 


Examining Outcomes

If SPY is below $200.00 at option expiration, our trader is going to buy those shares at $200.00—we refer to this as having the shares “put” to him. But if SPY is below $195.00, then he can exercise the options he owns, the 195 strike puts and sell the shares back out at $195.00.


Our trader received a net of $1.36 for selling each put spread, or a total of $2.34 million. That will be a pretty nice payday if he gets to keep it all. But what does SPY have to do for him to keep all of that money? He needs SPY to be above $200.00 at the February option expiration. 


Because SPY was at $201.63 when he exectuted these spreads, SPY can move higher, move sideways or even drop a little as long as it remains above $200.00 at option expiration. You can see the payoff profile at expiration below.  


Limiting A Losing Scenario

Even if SPY were to drop all the way to zero by February expiration—a pretty unlikely outcome, the worst that would happen to our put spread seller is that he would have to buy 1.72 million shares of SPY at $200.00 and then he would sell them at $195.00. 


His loss of $5.00 per share would be reduced by the $1.36 he received for selling each put spread. So his maximum net loss is $3.64 per share, or a total of $6.27 million. The fact that the maximum net loss is equal to the price received for selling the 200 strike puts is just a coincidence. 


As long as SPY is below $195.00, our trader will lose that net of $3.64 per share. But SPY was at $201.63 when these spreads were sold, so that’s not likely, and the options math tells us there’s a less than 30 percent likelihood that will happen.


And that same options math tells us the likelihood of keeping all that option premium collected is about 55 percent. 


Another Upside Scenario

And what happens if SPY is between $195.00 and $200.00 at option expiration? 


Our trader will have to buy the shares at $200.00, but he won’t want to exercise his 195 puts. That would mean he would sell his shares at $195.00 even though SPY is trading above that level.  Instead, he would let his 195 puts expire worthless and he would simply sell the shares on the open market.


With SPY below $200.00, and as long as SPY is above is the breakeven price of $198.64, the trade will be profitable. That said, the profit will be less than the maximum of 1.36. And below $198.64, this trade will be a loser.


Options on ETFs allow traders to speculate or hedge in a huge number of asset classes, and different options strategies allow them to create a trade that is appropriate for every risk appetite and every potential ETF price at option settlement. 

At the time this article was written, the author was long SPY and had a delta-neutral option position in SPY. Follow Scott on Twitter @ScottNations.


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