Setting Up With Puts For Big SPY Pullback

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 105 million options on ETFs were traded in May, 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.

The world’s largest ETF also had the world’s biggest net outflows in the first five months of 2015. And one big institutional options trader is worried that investors have good reason to be pulling their money out.

The SPDR S&P 500 ETF (SPY | A-98) had net flows of -$43.70 billion during the first five months of 2015 according to the ETF Fund Flows Tool on ETF.com. Some of that money was likely rotating into currency-hedged international ETFs but some was leaving the market, as analysts say a substantial pullback in the market is becoming more likely.

One institutional options trader agrees—enough to spend $3.2 million to buy SPY put options that will appreciate in value if SPY falls substantially.

While SPY is up only slightly in 2015, the three-year performance has been very impressive, with no pullbacks of more than 10 percent. 

Setting Up The Trade

Some institutional investors believe this leaves SPY vulnerable to a pullback. Specifically, if bad news causes all those who didn’t sell shares in the first five months of 2015 to sell at the same time, any drop in SPY could be sharp.

So on Tuesday, one institutional buyer paid $1.30 for 24,900 of the SPY $204 strike put options expiring on the last day of the quarter, June 30. These “quarterly” options are intended to help institutional traders and money managers hedge risk during calendar quarters since their performance is evaluated by the quarter.

These put options give the owner of the options the right, but not the obligation, to sell 2.49 million shares of SPY at $204.00 before that expiration date. Since the buyer paid $1.30 per share for the options, the breakeven point is $202.70.

SPY was trading at $211.36 when the trade was executed, so SPY would have to fall by just 4 percent for these puts to be profitable. That’s a much smaller drop than many analysts are looking for. But the drop would have to occur quickly because the options expire in less than one month.

Since owning the puts gives the right to sell the shares at the strike price, these puts will increase in value as the price of SPY drops. Meanwhile, the maximum potential loss is the price paid for the options—$1.30 per share, in this case. To be clear, each option corresponds to 100 shares of the ETF, so the maximum loss totals $3.2 million.

On the other hand, shorting shares of SPY would generate infinite risk since the loss from shorting shares increases as the price of SPY rises.

The $3.2 million spent is just a small portion of the total value of the corresponding shares. So, why don’t holders of SPY shares—we can’t know if this put buyer is protecting shares he owns or speculating that SPY will drop—constantly buy protective puts? Because these puts may represent just 0.6 percent of the value of the corresponding SPY shares, but they also expire in about one month.

If an owner of SPY shares were to buy protective put options every month, the annual cost would be about 7.4 percent, or nearly all, of the average annual return for the S&P. Protective options are expensive.

Options can be expensive. But if they’re used tactically, either to hedge an existing position or to speculate on falling prices, they can make tremendous sense, because they allow the hedger to continue to participate to the upside, and they allow speculators to define their risk.

At the time of writing, the author was long SPY and held a delta-neutral option position in SPY. Follow Scott on Twitter @ScottNations.