How This Put Option Spread On QQQ Worked

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.

Sixteen years ago, QQQ was the ETF everyone wanted to own. Now known as the PowerShares QQQ (QQQ | A-65), it debuted in March 1999 as the Nasdaq-100 Index Tracking Stock before sponsorship was transferred to PowerShares in 2007.

QQQ is still a power among ETFs, with more than $40 billion under management as of the close of trading on Tuesday.

But the largest components of QQQ reported earnings after the close on Tuesday, and one institutional options trader bought a put option spread to get lower cost exposure to the sell-off in QQQ. In doing so, he showed how buying a put option spread reduces the cost of exposure, by nearly 50 percent in this case, at the cost of limiting the amount of potential profit.

You can see that QQQ has performed magnificently over the past three years:

It would be easy to think that QQQ is due for a pullback, and one way to profit from a pullback would be to sell QQQ short. But that generates the potential for huge losses if QQQ rallies. So one institutional trader bought a put spread early in the trading day on Tuesday and got bearish exposure while defining his risk.

How The Trade Worked

The trader began by buying 4,500 of the QQQ August $112 strike put at $1.06. Since each option corresponds to 100 shares of QQQ, this gives the owner of the put option the right to sell 450,000 shares of QQQ at $112.00 per share anytime before the options expire at the close of trading on August 21. The total amount of premium paid to buy these puts was $447,000.

But that’s an awful lot of option premium to pay, so this trader cut the cost of the trade nearly in half by simultaneously selling 4,500 of the August $109 puts at $0.52. In doing so, he’s agree to pay $109.00 to buy back the QQQ shares he would sell at $112.00 if QQQ is below $109 when the options expire.

Doing both trades leaves our trader long the August 112/109 put spread for which he paid $0.54 per share, or a total of just $243,000. The maximum profit, as you can see below, would be $2.46 per share, or a total of $1.1 million, and that profit would be realized with QQQ below $109.00 at the August option expiration.

One of the benefits of most ETFs is diversification, and that’s the case with QQQ, so our put-spread buyer thinks it’s unlikely that QQQ will drop past $109 despite the disappointing news from Apple.

Buying a put spread also manages to take advantage of option skew, which means that as put options get further from at-the-money, they get more expensive on a relative basis. While the absolute cost of the put option falls as the strike price falls, the volatility required to make the option worthwhile increases as the strike price falls. This means our put-option buyer is getting a very attractive price for selling that $109 strike put.

Apple gave disappointing guidance during its earnings conference call following Tuesday’s close, so this trade is generating a profit, but QQQ will have to be below $111.46 at expiration if our trader holds it to expiration. We’ll keep track of this trade and update you.

At the time of writing, the author held no positions in QQQ. Follow Scott on Twitter @ScottNations.