ETF Options 101: 3 Ways To Short SPY

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.

Another Way To Short Spy
Another way to be short SPY, but without the need to be so exact—that is, without the need to see SPY fall so much before the trade is profitable—is to sell a call spread in SPY.

The seller of a call spread will collect the premium that is theirs to keep regardless of what happens to SPY. This means that selling a call spread will be profitable if SPY drops, but it will also be profitable if SPY moves sideways. With SPY at the same $192.90 level we discussed earlier, we could sell the November $195/$200 call spread at $2.30 by selling the November $195 strike call at $4.75 while buying the November $200 strike call at $2.45.

The $2.30 collected is ours to keep and the maximum loss is $2.70, which is equal to the width of the spread ($5.00) minus the premium collected ($2.30), or $2.70, as you can see:

The two trades are both bearish, although selling the call spread is also profitable if SPY is sideways to expiration.

Combining The Two
What happens if we combine the two trades by selling the call spread and using the proceeds to pay for a portion of the put we purchase?

The total cost would be dramatically lower than simply buying the put option, and we would see the trade generate a profit. This trade would cost $2.80, just over half of what the outright put purchase would cost. You can see how this trade makes money:

While combining the two trades gets pretty complicated, it shows what is possible with options.

Many investors think of options as just amplified long or short positions. However, only options allow investors to construct bearish positions that are fine-tuned to their precise market outlook—and to make money if SPY doesn’t move at all.

At the time of writing, the author held short cash-secured SPY puts in his personal account and his firm held a delta-neutral S&P option position. Follow Scott on Twitter @ScottNations.