Before getting to the trade, indulge me for a second while I show the value of selling puts in a broad based market index…
The CBOE S&P 500 PutWrite Index (PUT) is an excellent depiction of the benefits of selling puts. The chart below shows the performance of PUT versus the total return for the S&P 500 from January 1990 through the end of August 2015. Both returns are displayed assuming $100 was invested at the beginning of 1990. Note over time PUT outperforms the total return of the S&P 500 by about $150.
At this point some readers are thinking, “that’s great, but I’m not allowed to sell uncovered puts in my account”. Well there was a block trade I came across from Monday that appears to address this very issue.
The last big trade of the day this past Monday involved a trade that sold the RUT Sep 18th 1070 Puts at 5.37 and purchased the RUT Sep 18th 700 Puts for 0.10. That trade occurred when the Russell 2000 was quoted at 1159.42. Therefore as long as the Russell 2000 does not lose about 7.7% between the trade date and the middle of September this trade results in a winner equal to the 5.27 credit received when the trade was initiated.
If the equity market has a historic melt down and the Russell 2000 is at 700 or lower on September 18th settlement then this trade will incur a loss of about 454 points. Typically the purchase of a put in a bull put spread is done in order to limit losses. In this case the Russell 2000 needs to drop about 40% in two weeks for the 700 strike puts to begin to add value. When I see one of these trades where a deep out of the money put is purchased, my assumption is the motivation is more about being short a put, but not being allowed to have a ‘naked’ short put position due to a trader’s permission levels. It is a work around that allows trader to achieve a similar risk / reward that is associated with naked short put positions in cases where they may not be allowed to initiate uncovered short option positions..
For more on the CBOE Put Write Index visit www.cboe.com/put
For more on Russell 2000 Index Options visit www.cboe.com/rut