How To Earn Cash On XLE’s Further Decline

Shorting a put option on XLE can provide returns without buying the fund.

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Reviewed by: Scott Nations
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Edited by: Scott Nations

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. More than 110 million options on ETFs were traded in April, 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 examines the underlying options strategy.

 

As is well-known, energy prices have fallen over the past year, with crude prices down 43.9 percent.

 

In that same time period, the Energy Select SPDR (XLE | A-97) is down 19.6 percent. What if you thought XLE would be a bargain if it would drop just a little more; if you thought it might close part of the gap with crude oil? Is there a way to make money while you wait to see if you get to buy XLE at a discount?

 

One institutional options trader did just that on Tuesday.

 

As you can see, both crude oil and XLE have fallen during the past 12 months, but crude is much worse off than XLE:

 

 

If you wanted to buy XLE, but were only willing to pay a lower price than Tuesday’s close of $77.37, you might place a limit order to buy at, say, $75.00. If XLE trades below $75.00, you’ll have bought your shares.

 

But since you have to be willing to pay for the shares, you have to segregate all that cash without any assurance that you’ll buy the shares.

 

Getting Paid While Waiting

On Tuesday, one institutional options trader found a way to potentially buy XLE at a discount while getting paid as he waits. He did this by shorting a put option.

 

A put option gives the owner of the option the right—but not the obligation—to sell the underlying shares at a predetermined price, called the strike price, before the option expires.

 

The buyer of that option will pay the seller for that right. This means the put options seller collects that options premium from the buyer, but is now obligated to buy the shares if the options owner decides to sell them. The options owner will do so if XLE is below the exercise price of the option.

 

On Tuesday, when XLE was at $77,37, our institutional options trader sold 3,000 of the XLE $76 strike put options expiring on July 17. He received $1.16 for each share, meaning he collected a total of $348,000, since each option corresponds to 100 shares of XLE.

 

 

Keeping The Premium

This cash is his to keep no matter what. Since he sold the puts, he’s now obligated to purchase 300,000 shares of XLE at $76.00 per share if the owner of the puts elects to exercise them, which he’ll do if XLE is below that $76.00 exercise price when the options expire. But since our put seller gets to keep that premium, his net purchase price would be $74.84.

 

What if XLE isn’t below $76 at expiration? Then our put seller won’t be forced to buy the shares, the options he sold will expire worthless, he’ll pocket the $1.16 per share he collected and his duty to the option buyer will be extinguished. He could sell new puts in XLE or he could move on to a different trade.

 

This means there are three things that might happen to our XLE put seller:

  • XLE isn’t below $76 at option expiration. He doesn’t buy the shares and he gets to keep the option premium he received. This is ideal, since he would only buy XLE if he could do so at a discount, which didn’t happen, yet he got paid.
  • XLE is below $76, but above $74.84 at option expiration. He buys the shares because XLE is below the $76 strike price, but is trading above his net purchase price. This too can be ideal, since he bought the shares he wanted, did so at a discount to where they were trading at the time, and paid a discount to where they’re trading now.
  • XLE is below $74.84 at option expiration. This is not as bad as if he had simply placed a limit order to pay $76.00. 

 

 

Selling put options to buy stock at a discount is a fantastic strategy, but the emphasis should be on buying the stock—you have to be happy if you end up buying the stock. You’re not trying to dodge a bullet and just keep the options premium in this situation.


At the time of writing, the author didn’t own a position in XLE. Follow Scott on Twitter @ScottNations.

 

 

Scott Nations is president and CIO of NationsShares. NationsShares is a leading developer of domestic and international option-based and option-enhanced investment products. He is the creator of VolDex (ticker symbol: VOLI), an improved measure of option-implied volatility on SPY, the S&P ETF.