Selling SPY Put Options Like Limit Orders

Looking to buy the broad market at a discount? Here’s one way.

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.

Stock prices fell the last three days of last week, and closed on Friday with a 3.5 percent loss on the week. For ETF investors who feared they had missed the rally, and lamented not buying in September or October, last week’s decline offered an opportunity to get a bit of a bargain. And those who used a common option strategy could get an even bigger bargain.

The SPDR S&P 500 ETF (SPY | A-99) offers some of the most liquid options in the world, and as such, are a favored contract for investors seeking to create the sort of unique risk/reward profile that are only available to investors who use options.

And why generate those option-based risk/reward profiles? Because they’re often superior to the profile available to investors who eschew options.

SPY has rebounded nicely from August’s messy break precipitated by weakness in China. SPY traded above $211 earlier this month before rolling over—a disappointment for longs, but a relief for investors who had bailed on SPY in August:

Selling SPY Put Options

With prices lower and options more expensive (options generally get more expensive when markets fall), one institutional investor decided Friday was the time to sell put options on SPY.

Selling puts allows the investor to collect the premium paid by the buyer of the options—that premium is the put seller’s to keep—and potentially buy SPY at an effective price below where it’s currently trading.

On Friday, our institutional investor sold a total of 2,162 of the $190 strike puts expiring on Dec. 11 at $0.99. He collected $99 per option, or a total of $214,038. That cash is his to keep, but in exchange for that premium, our put seller agrees to buy a total of 216,200 shares of SPY at $190 per share if the owner of the puts elects to exercise his options, which he’ll do if SPY is below $190 at option expiration.

That means that below $190, his payoff is similar to an investor who owns SPY outright, as you can see:

The Payoff Profile

The payoff profile below $190 a share is similar to that generated by owning the shares, because our put seller will indeed end up owning those shares if SPY is below $190 at option expiration. But he will have bought SPY at a big discount. Since he’ll buy the shares at $190, but also has that $0.99 in his pocket, his net purchase price will be $189.01, a $13.53 discount to where SPY closed on Friday.

And what if he doesn’t get to buy SPY at that big discount? Then the options he sold will expire worthless, and he’ll get to keep the $0.99 per share, and his risk will have been extinguished.

Selling puts to buy stock at a discount is a bit like entering a limit order to buy SPY at $189.01 per share. The major difference is that SPY must be below $190 at option expiration to buy the shares.

So three things can happen when selling puts to buy ETF shares at a discount:

1. The shares don’t fall in price and we keep the option premium
2. The shares fall below the strike price ($190) but remain above our potential effective purchase price ($189.01), and we buy the shares at a discount to where they were trading when we sold the puts and at a discount to where they’re currently trading
3. The shares are below our effective purchase price and we buy them, but we buy them at a discount to where they were trading when we sold the puts

Selling puts to buy ETF shares is a great strategy, but it’s like buying the shares, in that you must be prepared, and have the capital segregated to buy if the price falls, which is often a great time to be buying ETF shares anyway.

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