Profiting On Options While Lowering Risk

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.

It’s a nice problem for an institutional option trader to have: You executed a trade just six days ago and it’s already a big winner. But what do you do now? Do you press your advantage or simply take the money and run?

One trader, faced with that question in a bearish option trade on the iShares Russell 2000 ETF (IWM | A-88), decided to press his advantage so that he can still profit, but also managed to nearly eliminate the risk from the trade.

IWM has had a pretty tough run; it’s lost more than 4 percent during the last 30 days and traded below $120 on Tuesday, the first time it’s done so since March.

IWM tried to stage a rebound during the middle of July, but once it started to roll over again, one institutional option trader placed a bearish bet on July 22 by buying the September $123 strike puts. The volume that day was more than 12,000 option contracts, so we have a rough idea of the size of the original trade, and it’s likely they paid about $2.50 per option.

Since then, IWM has fallen by $3.28, and the value of these puts has nearly doubled. If our trader thought the bottom was in for IWM, he might simply sell his options and pocket his profit. But our trader doesn’t think the bottom is in for IWM, so he decided to roll his long position in the $123 strike puts down to the $118 strike, maintaining bearish exposure to IWM, and pocketed about $2.18 per share in the process.

Staying Bearish, But Taking A Profit
How did our trader do this? He was long the $123 strike puts, so he sold 10,431 of those at $4.63; we can assume that is the number he bought originally. To maintain bearish exposure, he simultaneously bought 10,431 of the $118 strike puts at $2.45. Our trader rolled his position down to a lower strike price—the $123 strike price to the $118 strike price—by selling a put spread, the $123/$118 put spread in this case.

By rolling the position down, our trader has pocketed approximately $2.18 per spread, or a total of about $2.3 million, reducing his risk from the approximately $2.50 originally paid to about $0.32 per share, yet he’s maintained bearish exposure to IWM.

Since he’s closed his position in the $123 strike puts, he’s left long 10,431 of the September $118 puts. That means he now has the right, but not the obligation, to sell 1.04 million shares of IWM at $118.00 any time before the options expire on Sept. 18.

What does the payoff profile for this new position look like? If we treat his position as if he’s long the $118 puts at $0.32, it looks like this:

Reducing Risk Reduces Return

Is there any reason not to roll down to reduce risk like this trader has done? Certainly! The breakeven point is now lower. It was about $120.50 previously, but it’s $117.68 now. And the new option is much less sensitive to any drop in IWM. Given Tuesday’s closing prices, the $123 strike put would expect to gain about $0.57 for each $1.00 drop in the price of IWM, while the $118 strike put would expect to gain just $0.32 for the same drop.

While buying options is popular because the risk is defined, it’s also difficult to consistently make money doing so. Over time, options tend to cost more than they’re worth, just like any other form of insurance. So managing a long option position is imperative.

Our trader has gotten himself into a position where if his market thesis was correct, he made money. He’s also managed his position so that his loss potential is now nearly zero while his profit potential, if IWM continues to drop, is huge.

At the time of this writing, the author did not hold a position in IWM. Follow Scott on Twitter @ScottNations.