Buyside Strategies EQD Research

EQD Research: Large Hedges Came In As Nasdaq-100 Was Hitting All-Time Highs

Sep 9, 2020

By Russell Rhoads,
head of research

In late August, as the Nasdaq-100 (NDX) and QQQ ETF continued to make all-time highs, one large trader seems to be preparing for a retracement of 2020’s big move.  The time frame for these trades appear to be hedging against a drop in the next six months or so since the options all expire in March 2021.  The most recent trade occurred on Thursday August 27, with QQQ at 291.90.  A trader came in purchasing 50,000 of the QQQ Mar 255 Puts for 13.89 and selling 50,000 QQQ Mar 230 Puts for 8.59 resulting in a net cost of 5.30 points per spread.  The payoff if held through March expiration appears below.

The long strike price of 255 is 12.6% lower than where QQQ was trading when the trade was executed and anything short of this price level results in a maximum loss of 5.30 at expiration. Break-even at expiration for this trade is 14.3% lower. The maximum potential gain, again at expiration, is 19.70, which would be the result if QQQ is 21.2% lower than the market price when the spread was executed.

A few aspects of this trade lead me to believe this was a hedge as opposed to a speculative trade anticipating a 20% drop in the NDX sometime between late August and the third Friday in March.  First, is the sheer size of the trade.  A 50,000 lot in QQQ options is the equivalent of 5,000,000 shares.  This comes to a over $1.4 billion in exposure to the QQQ ETF.  The other factor relates to the lower strike price being about 20% lower than where QQQ was quoted when the trade was executed.  That 20% number is often a key level where market participants declare a bear market.  It also can be a level where buyers start coming back into the market which makes it a favorite of put spread buyers who are using options to hedge as opposed to speculate on a move.

Out of curiosity, I decided to go through the trading tape and determine what NDX trades would achieve the same exposure as this QQQ trade.  At the time the QQQ put spread was executed, NDX was quoted at 12,003.  The appropriate strikes that achieve a similar risk profile to the QQQ put spread result in buying the NDX Mar 10,500 put for 571.10 and selling the NDX Mar 9450 Put for 351.30 resulting in a cost of 219.80 points per spread.  The same market exposure as the 50,000 lot QQQ spread may be achieved by trading 1220 of the NDX spreads since the QQQ price is usually about 1/41st the size of the NDX quote.  The payout diagram below highlights the long strike (down 12.5%), break-even (down 14.3%) and short strike (down 21.3%) levels relative to where NDX was quoted when the trade was priced.

It turns out, the Thursday trade was one of three very similar 50,000 lot QQQ bear put spreads initiated over three consecutive days. On Wednesday August 26, with QQQ at 288.26 there was a buyer of 50,000 Mar 255 puts at 13.70, who sold 50,000 Mar 230 Puts for 8.41 and a net cost per spread of 5.29.  This trade used the same option contracts as the Thursday trade, but paid a penny less.  The payoff diagram below shows the result of this trade if held through expiration.

The important levels are similar to those for the Thursday trade with break-even 13.7% lower than the QQQ price when the spread was executed.  The maximum loss is equal to the price paid for the spread (5.29) with a maximum potential gain of 19.71 if QQQ is at or below 230 at expiration, a drop of 20.2%.

Pricing this trade out using NDX options results buying 1220 of the NDX 10,500 puts for 562.50 and selling the NDX 9450 puts for 342.00 resulting in a net cost of 220.50 points per spread.  Note, both the Wednesday and Thursday versions of the NDX trade use the same options, as did the QQQ trades.  The outcome at expiration for the NDX version of the Wednesday QQQ trade shows up below.

The high strike put option is 11.5% lower, break-even involves a market drop of 13.4% and the spread ceases adding to profits if NDX is down 20.4% or more.

Finally, there was a 50,000 lot QQQ put spread executed on Tuesday, August 25 with QQQ trading at 284.25.  The strike prices were slightly different since QQQ was at a lower level.  For this trade there was a buyer of the QQQ Mar 251 puts for 13.49 who then sold the QQQ Mar 225 puts for 8.02 resulting in a net cost of 5.47 points per trade and a payoff, if held to March expiration, that looks like the payoff diagram below.

Note the spread between the option strike prices is one point wider than the first two trades in this article. The 251 long put strike price is about 11.7% lower than where QQQ was trading when the this spread hit the tape. Break-even is 13.6% lower and the short option strike (225) is a little over 20% lower. The risk for this trade is 5.47 while the potential maximum gain is 20.53.

Finally, the Tuesday QQQ trade was executed when the ETF was at lower price levels so the NDX version also uses different options relative to the first two examples.  NDX was at 11,656 which results in a trade that buys 1220 NDX Mar 10,300 puts for 556.90 and sells the Mar 9250 puts for 337.70 resulting in a cost of 219.20.

Again, the various significant price levels match up with the trade using QQQ options.  The long strike is down 11.6%, break-even 13.5%, and profits are capped at a move lower of 20.6%.

A little digging found the same outcome for the three large QQQ trades from last week may also be achieved using significantly fewer NDX options.  There are other benefits to using index options instead of options on ETFs, such as favorable tax treatment and cash settlement versus physical settlement.    It appears the trader of these three 50,000 lot QQQ spreads they may have achieved the same exposure with NDX options with a much smaller contract size trade.