This is a weekly column focusing on ETF options by Scott Nations, a financial advisor with about 20 years of experience in options. Almost 112 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 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.
It seems the U.S. stock market is never going to go down again. Early last week had some tough talk from Federal Reserve governors about the possibility of mounting inflationary pressures and while markets briefly rolled over a bit, we’re back to all-time highs.
If you want to buy an ETF, but fear buying at that all-time high, there’s a simple option strategy that allows you to effectively bid for an ETF at a price lower than the current price, yet get paid for your trouble if you end up not having your buy order filled. That strategy? Selling a put option. But as the saying goes:“The right thing at a wrong time is a wrong thing.”
The tool of choice is the iShares Russell 2000 ETF (IWM | A-84). It’s one of the most popular ETFs among option players, who traded more than 36 million IWM options in May. On Tuesday, a large block of IWM put options sold. So, is this a case of doing the right thing at the wrong time?
A put option gives the owner of the option the right to sell the underlying ETF—IWM in this case—at the strike price of the option any time before the option expires. The seller of the put option agrees to buy those shares at the strike price of the option and receives the option premium from the buyer for agreeing to do so.
If the seller of the put option ends up buying the shares, his effective price is the strike price of the option less the premium received. Depending on the strike price and premium received, this effective price can often be dramatically lower than where the shares were trading when he sold the put option. If he doesn’t end up buying the shares, he pockets the option premium he’s collected.
And that’s just what our put option seller in IWM did on Tuesday. Below is the one-year chart of IWM.
He sold 26,000 of the July $114 puts at $1.38. Since each option corresponds to 100 shares, he collected $138.00 for selling each option, or a total of nearly $3.6 million. That money is his to keep no matter what.
If IWM is below the $114 strike price at July expiration—the close of trading on July 18, to be exact—then the owner of the option is going to exercise his options and sell IWM at $114.00, and our put seller will be obligated to buy the shares at $114.00 regardless of how much below $114.00 they’re trading. Since he collected $1.38 for selling each option, his effective purchase price is $112.62, or 3.7 percent below Tuesday’s closing price of $116.97.
Buying at a nice discount is, well, nice. But again, is this the right trade at the wrong time? It would be if the price received for selling those puts was low, given the risk of having to buy IWM. So, let’s look at the historical price of options on the Russell 2000 Index to get a better sense of where things stand.
As you can see, the price received for selling options on the Russell 200 Index, on which IWM is based, is historically low; it’s been lower than it is now on only 20 days this year. While selling puts to buy stock at a discount is generally a great strategy, selling the puts themselves at a discount isn’t such a great strategy.
So, if this put seller would have an effective purchase price of $112.62, just where is that price on the one-year chart of IWM?
You can see that IWM has spent most of the past year below that $112.62 level. It was below there as recently as the first week in June, and was below $109.00 as recently as the middle of May.
Selling puts to buy stock at a discount is a great strategy—if you’re actually willing to buy the stock at that effective price. But you shouldn’t be trying to dodge a bullet to keep that option premium received.
At the time of publication, the author held no positions in IWM or IWM-related options. Follow Scott Nations on Twitter @ScottNations.