The S&P 500 fell close to 3% over the first two days of October, revealing a common pattern for institutional option traders, as the US stocks index quickly erased gains from September and moved back to August lows of around $2887.
As a result, traders sold large blocks of puts – which is a contract giving the owner the right to sell an asset at a predetermined price within a specified timeframe – to open with January 2020 expirations across nine large-cap stocks that were mostly consumer-driven names.
Retail traders, meanwhile, sold puts in Walmart [WMT] and Target [TGT]: two household names that have been outperforming the rest of the US stock market so far in 2019 and tend to outperform in slower growth environments.
In the home improvements sector, put sellers – which refers to when a put option is exercised and the underlying shares are sold at the strike price – targeted retailers such as Lowe’s [LOW] and Home Depot [HD] as well as key supplier Sherwin-Williams [SHW]. Puts were also sold in payment processing stocks too, including Visa [V] and Mastercard [MA].
The option positions being placed in October
Looking at the option positions being placed, it is evident that traders were selling mostly -20 to -30 delta puts, which refers to the ratio that compares the change in the price of an asset to the corresponding change in the price of its derivative.
Implied volatility – a metric that captures the market’s forecast of a likely movement in a security’s price – was mostly in the 20% to 30% range and probability of expiring was worthless, while keeping the full premium collection near 70%.
The chosen put strikes were around 10% out of the money, or OTM which is a term used to describe an option contract that only contains intrinsic value, across the names. If you take the strike minus the option price, you have the cost-basis and the break-even level for reference.
Looking at the stocks chosen, there are also some key themes, mainly in mega-cap names with market caps over $50bn, the lone exception is Autodesk which also does not fit the consumer-centric theme and may not be related to the other eight.
The stocks chosen are also high-quality names with strong share price performances YTD and non-egregious valuations. The main eight all pay dividends and are considered to be low-volatility safer plays that should outperform in a more turbulent market.
The “smart money” trades are essentially showing a willingness to own high-quality businesses into another 10% decline while taking in multi-million dollars in premium.
“The “smart money” trades are essentially showing a willingness to own high-quality businesses into another 10% decline while taking in multi-million dollars in premium”
Selling cash-secured puts vs naked put selling
Although naked put selling – an options strategy where a trader sells put options without holding a short position – is not for everyone, I have had this conversation many times with peers regarding the allure of the strategy.
In my opinion, it almost never makes sense to buy an equity that trades liquid options because it is a much better strategy to sell puts and collect the premium the market is giving you while defining exactly the level you are willing to be a stock owner.
It especially makes sense when names you want to own become oversold and implied volatilities rise with the overall market environment allowing for a higher premium collection.
And it makes even greater sense when we are in a “baby with the bathwater” situation, which is basically when equities are all moving lower together due to a broader risk-off move and not taking into account the micro-level fundamentals of individual stocks.
“It almost never makes sense to buy an equity that trades liquid options because it is a much better strategy to sell puts and collect the premium the market is giving you while defining exactly the level you are willing to be a stock owner”
As it stands, we are seeing markets weaken on concerns of slower global growth, but the data has yet to show a slowdown for US consumers, an area that remains healthy. The data also indicates that traders are targeting names that outperform in slower growth environments.
Looking at things from a more technical basis, we have been in a sideways market for nearly two years now. However, as markets move towards the lower end of the range, selling puts can be very effective where time decay of options works in your favour and these short bursts in volatility do tend to fade.
In terms of risk-management, selling cash-secured puts is always recommended over naked put selling, as traders are more willing and able to take delivery of the stock.
The other drawback often mentioned with selling puts is the lack of participation in an upside reversal outside of just the collected premium.
One can offset this through a risk-reversal strategy, which is a combination of selling out-of-the-money puts and buying out-of-the-money calls, however, this tends to be most attractive when done for a net credit so you are still utilising the optimal dynamics of a put sale strategy.
By Joe Kunkle, who is the founder of Options Hawk, a service that provides news, analysis and option movement research. Alongside this, he runs his personal trading account and is head research analyst at investment firm Relativity Capital.
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