The S&P 500 lost 0.01% yesterday, which was the fourth straight day of losses for the market. That said, the losses were more significant in the morning but the market staged a rebound midway through the day.
When the market sells off (the S&P 500 2.5% off all-time highs is hardly a large selloff), many traders use the selloffs and the increase in option volatility to their advantage. One way to take advantage of these market conditions is to sell puts, also known as Put-Writes.
A Put-Write strategy is used when a rise in the price of the underlying asset is expected, or a significant decline is not expected.
This strategy is often used by traders who are willing to enter a long position in a stock at a price lower than the stock's current price.
This strategy entails selling a put at a specific strike price. It has the potential for loss until the stock hits zero. The maximum profit on the trade is the amount of premium received.
If I were to sell a put, and the stock went below my put's strike price, I would be assigned 100 shares per put I've sold, thus making me long 100 shares per put sold.
Yesterday, a large trader executed a Put-Write in Horizon Pharma (HZNP) in a massive way. With HZNP trading lower by $0.85, at 31.50, a trader throughout the course of the day sold 21,000 June 30 Puts for an average price of $0.30. The trade will expire in eight trading days, on Friday, June 19.
Here are the scenarios on how the trade will, or will not work:
If HZNP closes at 30 or above on June expiration, the trader will collect $630,000. The math behind this is 21,000 multiplied by $30 = $630,000.
The breakeven on this trade is 29.70, as the trader collected $0.30 with the sale of the puts. The math behind this is 30 minus $0.30 = $29.70.
If HZNP closes below 30, the trader, if he does not buy back the puts he sold, could be forced to buy 2,100,000 shares of HZNP, a capital outlay of $63,000,000.
Here is the profit and loss graph of this trade:
I really like Put-Writes, as they're a great way to create yield in stocks I'm willing to own. But I don't like the risk/reward in this trade. While I think the trader will likely collect his $630,000 next Friday, as order flow has been very bullish in HZNP for the past several weeks, the downside is too high if the market were to sell off in a big way.
This trade was likely executed by a large hedge fund or trading desk, which is perfectly willing to buy 2.1 million shares of HZNP at 30, and if the stock does not drop below 30, the trader will have created a great yield in a week and a half.