A Deep Out-of-the-Money NDX Put Spread and the Logic Behind an Early Exit

In mid-January there was an interesting trade that hit the tape over a couple of days. On Monday January 12, with NDX around 25,719, a trader sold about 1700 NDX Feb 6th 22000 Puts for 19.25 and purchased the same number of NDX Feb 6th 21900 Puts for 18.25, taking in a credit of 1.00. A couple of days later, on Wednesday January 14, they sold 1700 more NDX Feb 6th 22000 Puts at 29.57 and purchased the 21900 Puts for 27.89, taking in a credit of 1.68. This trade was executed when NDX was a bit lower at 25,350. The net result was a position short 3400 NDX Feb 6th 22000 Puts and long 3400 NDX Feb 6th 21900 Puts at a net credit of 1.34 pre spread.

Data Sources: Bloomberg and Author Calculations

Note the upper strike price of the spread is about 13.83% lower than the average where NDX was quoted when the trade was executed as is the down 14.23% which would result in a maximum loss of 98.62. This trade was executed a few weeks ago, but we are talking about it now because it appears they exited the trade on Monday, February 2.

The specific execution on February 2, purchased the NDX Feb 6th 22000 Put for 1.51 and sold the NDX Feb 6th 21900 Put for 1.38 and a cost of 0.13. The net result is a gain of 1.21 per spread.

Tape reading involves some assumptions as to the thinking behind a trade and we have a couple of thoughts around this one. First, in January, we saw the trade and investigated losses of 13.83% or more over an 18-day period, which is the amount of time from the first execution to February 6 expiration. Our first guess was the year 2020 for the last loss that would put this trade in danger. However, it turns out in May NDX lost over 13.83% in an 18-day period as recently as 2022. Between April 19, 2022, and May 12,2022 the NDX dropped 15.94%. A drop of this magnitude would result in the maximum loss for this trade. Based on that, this trade did not appear attractive to us.

A second thought was around why the trader did not just let this trade expire out of the money Friday. Of course, that only works if NDX does not break the 22,000 level this week, which appears unlikely with NDX well over 25,000. One thought it maybe they needed to free up capital for another trade, which would make sense. The other thought is a stretch, but they may make more off the capital requirement for the trade through the risk-free rate. In that case, why do you take on the miniscule risk of a loss in this trade when interest made on the capital is equivalent or better.