Author's note - this is an updated blog from last week correcting the strike of the short put. Thanks to Robert Shen for the catch.
Volume continues to rise in the Russell 2000 (RUT) option arena and my choices among block trades to discuss are on the rise as well. A trade from this past Tuesday caught my eye for three reasons. First, it was not a short dated deep out of the money credit spread – most of the trades I’ve come across and discusses recently in this space fit that description. Second, it is focused specifically on an outlook that matches the end of the first quarter which gives me a good chance to highlight quarter end options. Finally, it is what I consider a retail version of a cash secured put.
The specific trade was done in three lots mid-day on May 19th when the Russell 2000 was hovering around 1253. The size and option prices are approximations with the math being kept simple so we can focus on the concept behind the trade. About 3,000 RUT Jun 30th 1160 Puts were sold for 5.24 while the same number of RUT Jun 30th 850 Puts were purchased at 0.22. The net result is a credit of 5.02 and a payout at expiration that matches the diagram below.
This trade is an out of the money put spread, but the timing is a little longer than the majority of block trades I’ve written on in this space over the past few weeks. The specific timing is for the end of the second quarter with the Jun 30th RUT series being traded. Finally, the 1160 Puts, which were over 8% out of the money at the time of the trade were sold short and the 850 Puts were purchased. Many brokers will not permit most traders to sell short options without having some sort of offsetting position. Since the 850 Puts are more than 30% out of the money, my assumption is that this trade has the same mentality that would go along with a naked short position in an out of the money put.
The end result is a spread that pays off just of 5.00 per contract as long as the Russell 2000 June 30 settlement levels is over 1150. The break-even level for this trade is 1154.98 which is 8.4% lower than where RUT was quoted when the trade was executed. Finally, there is a lot of downside risk, but it is capped at a drop of just over 32% which is a pretty huge drop for just a few weeks of market action.