Bearish Vertical and Ratio Spreads
A number of big prints in the iShares Emerging Markets Fund (EEM) Tuesday morning and the activity seems to reflect concerns about the outlook for the emerging markets in the weeks ahead. At the top of the list is 50K May 40 – 43 put spreads apparently bought at 84 cents on ISE. Next is a Jun 38 – 42 (2X1) put ratio spread apparently bought at 44 cents, 23330X on PHLX. Separately, a block of 20K May 42 puts was bought-to-open at 97 cents on ISE. Finally, the action includes a Sep 32 – 42 put spread bought at $2.27, 8900X on AMEX. Shares are down 44 cents to $42.99 and all of these positions seem to be in anticipation of additional weakness in EEM.
Let’s look at the two biggest trades, which are probably hedges and not necessarily bearish bets. Yet, when a spread involves a total of almost 100K contracts it’s certainly worth noting because the decision to initiate the trade is probably done after careful research. After all, the commissions alone are likely to cost $100,000 ($1 per contract at many institutional shops.)
The first spread is straightforward. With shares around $43, the strategist is buying 43s at $1.27 and selling 40s at 43 cents. The action is in May, so this is a play over the next few weeks (38 days to be exact.) Excluding commissions, the potential pay-off is $3 minus the net debit (.84) or $2.16. The debit is at risk if shares hold above $43. So, the strategist is risking 84 cents to make $2.16, a ratio of about 2.5-to-1.
The second spread is a June put ratio spread that is slightly more bearish. The strategist is buying the 42s and selling twice as many 38s, at a 44-cent net debit. The potential pay-off is $3.56 if shares fall to $38. So, the strategist is paying 44 cents to make $3.56, which is a significantly greater ratio than the first vertical spread for two reasons: 1) the puts are farther out-of-the-money and 2), the strategist is selling 2 puts for every put option purchased.
The fact that they are “naked” on 23,330 puts leaves them exposed to more risk should shares really tank. For that, reason, it’s often better to use a put butterfly spread and, for example, also buy the June 34 puts as a hedge. That is, sell the 38s for the body of the fly and buy the 42s and 34s as the wings. The third leg (June 34s) would serve as a hedge should the share price really fall a lot more than expected. In this case, however, the strategist is probably not looking for a move substantially below $38 by mid-June.
Category: All ETFs
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About the Author (Author Profile)
Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.
I hope these big players are right as I bought a May 42-40 put spread a couple of weeks ago.
Seems like there’s a shift in sentiment lately. XRT seeing bearish trading today and yesterday. Big spreads in EWZ last week. Probably hedging activity with implied volatility so low, but it’s a very interesting uptick in activity.
Another interesting thing is that, while the ETFs are seeing a lot of bearish trading, there’s a lot of bullish trading and speculative activity in the individual names. 10.1 million calls and 5.4 million puts traded yesterday. I was having a hard time finding any bearish stories to write about! With VIX falling to levels not seen since July 2007, the uptick in call activity could be contrary signal to exercise some caution here.