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ETF Options: An HYG Put-Play Revisited

Scott Nations

This is a weekly column focusing on ETF options by Scott Nations, a financial advisor with about 20 years of experience in options. Almost 107 million options on ETFs were traded in June, 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 option trades to help readers understand where traders believe a particular ETF may be headed. In doing so, Nations will examine the underlying options strategy.

Last week we examined a bearish put options trade risking $455,000 that could make millions in profit if the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-69) finally rolls over, as many have been expecting for months.

To do so, HYG must sustain at least a 13 percent drop in the next 70 days. That sort of move is pretty unlikely, so it’s fair to say this trade is “swinging for the fences.”

You can see why a trader would think HYG is vulnerable; it’s as much about the “corporate” as it is about the “bond”—if you compare it with a straight bond fund, such as the iShares 7-10 Year Treasury Bond ETF (IEF | A-51), and a straight equity fund, the SPDR S'P 500 ETF (SPY | A-98).

Given that the first few days of this week have been ugly for SPY and the rest of the stock market, let’s re-examine this bearish trade in HYG and see how “Swing for the Fences Sammy” is making out.


Last week, he bought 13,000 of the September 90 put options in HYG, giving him the right, but not the obligation, to sell 1.3 million shares of HYG at $90.00 a share any time before the September option expiration. If HYG is below $90.00 at option expiration, he can buy the shares lower, sell them at $90.00 and pocket the difference.

He paid $0.35, or a total of $455,000, for his options and he’ll lose all of that if he holds his options to expiration and if HYG hasn’t dropped below the $90.00 strike price.

As of the close of trading a week later, HYG has dropped slightly, from $94.81 to $94.68, so things are heading in the right direction. But at this rate, HYG is never going to drop far enough or fast enough to be profitable, as you can see from the payoff chart for this trade:



And that’s just what’s happening to this trade.

While HYG is headed in the right direction, time is headed in the wrong direction for our put buyer. As time passes, his options erode in value, and even though HYG is slightly lower in price since he bought these puts, the puts haven’t moved in value. They closed at $0.35 on Tuesday, July 8. In other words, they’re worth the same $0.35 he paid.

It’s tough to get rich if your trade breaks even.

Is there another options strategy that would have spent roughly the same amount of money differently, while still limiting our risk, yet would have increased the odds of making money from the 13 percent likelihood that we saw when Sammy initiated this trade?

Here’s an idea:What if we bought a put option with a strike price that was closer to where HYG was trading at the time—$94.81, but then sold another put option with a lower strike price to reduce the cost? That’s called a “put spread,” and it would certainly increase the odds of being profitable without spending much extra money, though there is one important caveat.

You can see a put spread in HYG that could have been executed instead, but that would have been much more likely to generate a profit. The trade-off? This trade costs an extra $0.05 and limits the profit if HYG drops substantially.


Let’s look at the same sort of payoff chart for this trade:



If you compare the two payoff charts, you’ll notice that HYG doesn’t have to drop nearly as far in order for this trade to break even and start making money. The outright put purchase had a breakeven price of $89.65, while our put spread has a breakeven price of $92.60.

Some simple options math can tell us the likelihood of that outright put purchase being profitable when it was initiated was about 13 percent. So, what’s the likelihood? About 40 percent.

Of course, buying any options spread limits our potential profit, and if HYG drops substantially, then we’ll regret using a higher-probability spread over a lower-probability outright put. You can see the point where we regret our decision below:


With HYG at $88.05, the two trades generate the same profit of $1.60 at option expiration, but the profit from the spread has reached its maximum level, while the profit for the outright put option will continue to increase. Which is the right trade?

The value of the 90 strike put hasn’t changed despite HYG dropping slightly. However, the value of the put spread has increased from $0.40 to about $0.45 because HYG has dropped. Still, erosion is driving down the value of both options, and that hurts us with the 93 strike put we’re long on, but helps us with the 91 strike put that we’ve shorted.

But the real measure of which trade is best is the final outcome and how it meshes with our outlook for HYG during the term of these options.

One thing is certain:Novice ETF option traders tend to initiate too many of these “swing for the fences” trades. Options trading tends to be much more profitable over time if you try to hit lots of singles and doubles.

This HYG trade was obviously initiated by a professional given that total amount of premium spent, but we’ll continue to monitor the trade to see how both structures play out.

At the time this article was published, the author had no positions in IEF or HYG, but did own SPY. Follow Scott on Twitter @ScottNations.


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