Jumping on Juicy Premiums on a Bad Day for Small-Caps

Hey Traders,

Along with most other stocks, small-caps took it on the chin yesterday, amid concerns about another spike in global coronavirus cases.

A new COVID-19 variant is apparently spreading across Europe, deaths in Brazil just hit a new peak, and some states could put reopening plans on hold.

While the spring breakers in Miami Beach don’t seem to mind, the good ol’ VIX climbed back above 20, while the Dow and Nasdaq each dropped triple digits Tuesday.

It was even worse for the Russell 2000 Index (Ticker: RUT), which succumbed to its worst day since June, and its corresponding fund — the iShares Russell 2000 ETF (Ticker: IWM) — also took a hard spill, falling 3.6% to just above $217.

However, one option trader yesterday looked to capitalize on that JUICY volatility …

And it looks like they think the small-cap blood-letting is about to come to an end.

Capitalizing on Chaos

It appears the option trader in question may have sold to open a boatload of deep out-of-the-money (OTM) puts on IWM.

Specifically, we saw a block of 20,000 June 173-strike puts cross the tape around the bid price of $1.64.

Courtesy of Trade-Alert

What does that mean?

In a nutshell, it means a big-league customer may have tried to capitalize on yesterday’s stock market chaos, and can capture some potentially major premiums if IWM doesn’t fall below the $173 threshold before June expiration.

(If it feels like I’m speaking a foreign language, join me and my colleagues as we LIVE TRADE and TEACH ALL DAY ON TOMORROW! In the meantime …)

By selling puts to open, you’re basically drawing a line in the sand … 

You’re saying you don’t expect the underlying shares to move south of the strike price within the option’s lifetime.

The most a put seller can make is limited to the initial premium received — $1.64 a contract, in this case — so this strategy is often utilized when premiums are juicy.

And when are option premiums the juiciest?

When volatility is high!

That’s because “volatility” is just another word for “wild and unpredictable,” and when a stock — or ETF, in this instance — is wild and unpredictable, a lot more option strikes are in play… 

No one knows where the underlying will go next, right?

So a strike that once seemed waaaay out there feels a lot more plausible when there’s anarchy on the charts…

And if it’s a plausible strike (albeit remotely), people will pay up to play it.

It’s the name of the game.

With that in mind … as the RUT and IWM were falling apart yesterday, the option trader at hand attempted to take advantage of the creeping fear on Wall Street …

Which is how he or she managed to get even $1.64 for an option that’s still about $44 out of the money (and was even deeper OTM at the time of the put-sell).

Think about it — that $1.64 is ALL extrinsic value, which is mostly just time (about two months’ worth, in this case) and implied volatility.

I mean, you can see on the image below that IWM hasn’t been below the $173 level at all in 2021 … Not since November, in fact. 

My colleague Licia Leslie will talk trading off candlesticks tomorrow at our LIVE Expert Huddle!

And prior to yesterday’s 20K-contract trade, there were fewer than 500 open puts at that June 173 strike…

Which tells me not many traders were watching this relatively obscure, OTM strike prior to that trade, and for good reason: because a drop that far and that fast would be on par with the crash we saw about this time last year.

That’s not impossible, I guess… but it’s highly unlikely.

And the put seller knows that.

My gut tells me this trade was about striking while the vega iron was hot, and trying to capture a really nice yield on an option that’s far OTM. 

I’d be surprised if the put seller plans to be in these longer than a month. Instead, he or she will likely ride that time decay and let things cool down, then close these suckers on a rich note.

Your Only Option,

Mark Sebastian

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