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. Almost million options on ETFs were traded in December , 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 will examine the underlying options strategy. ETFs and options on ETFs are wonderful tools for active traders.
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Also, the growth in options trading and options education means that more and more traders take advantage of the nearly infinite number of strategies options can offer. In the s, retail traders could only read about the high-yield debt market. Now there are more than a dozen high-yield debt ETFs, many with very liquid option markets.
The same was true for international equities. Traditional mutual funds existed, but they were subject to style and geography diffusion, and if you thought one of those markets was going to go sideways, there was no options market that would allow you to execute a strategy to take advantage of that.
But option traders are better off today, even in those underlying indexes that were available before the advent of ETFs and options on those ETFs. This liquidity means that multileg spreads and combinations allow a trader to make a defined-risk trade that SPY will go up, down or sideways. And one institutional trader did just that in SPY on Tuesday. SPY has traded in a relatively narrow range—narrow being a relative term—since the beginning of the year as you can see.
It might seem that SPY has bounced around during the first 12 trading days of , but since SPY was launched in , the average range for SPY over the first 12 trading days of the year is 5. If a trader thought that sideways price action would continue with the possibility that SPY would resume its march higher, there are several option strategies she might use to profit.
But one of those strategies has the advantage of making money if SPY does nothing, moves higher or even if it moves a little lower and does so while limiting risk. So what is this wonderful trade that limits risk but generates return given a variety of outcomes?
Selling a put spread.
He sold a total of 17, of the SPY strike puts expiring in February and bought the same number of SPY strike puts expring at the same time in order to limit his risk. By selling them, he has committed himself to buying 1.
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That will be a pretty nice payday if he gets to keep it all. But what does SPY have to do for him to keep all of that money? You can see the payoff profile at expiration below.Common mistakes made trading the the SPY
Even if SPY were to drop all the way to zero by February expiration—a pretty unlikely outcome, the worst that would happen to our put spread seller is that he would have to buy 1.
The fact that the maximum net loss is equal to the price received for selling the strike puts is just a coincidence. And that same options math tells us the likelihood of keeping all that option premium collected is about 55 percent. Instead, he would let his puts expire worthless and he would simply sell the shares on the open market.
That said, the profit will be less than the maximum of 1. Options on ETFs allow traders to speculate or hedge in a huge number of asset classes, and different options strategies allow them to create a trade that is appropriate for every risk appetite and every potential ETF price at option settlement. At the time this article was written, the author was long SPY and had a delta-neutral option position in SPY.
Follow Scott on Twitter ScottNations. View the discussion thread. Skip to main content. Inside The World Of SPY Options Trading January 22, Anatomy Of An Options Trade On Tuesday, one institutional options trader sold a bunch of put spreads on SPY.
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Limiting A Losing Scenario Even if SPY were to drop all the way to zero by February expiration—a pretty unlikely outcome, the worst that would happen to our put spread seller is that he would have to buy 1. Find your next ETF Asset Class: All Asset Classes Alternatives Asset Allocation Commodities Currency Equity Fixed Income.
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