The wave of volatility that washed over the markets this week sent the financials falling.
The XLF, the ETF that tracks the sector, is down 2% as worries about global growth and the U.S.-China trade war remain center stage. Despite the losses, the XLF is still up more than 15% this year and outpacing the S&P 500, but that isn't stopping one options trader from making a big-time bet against the group.
"We saw a big put spread trade ... [a buyer of] the June 27/24 put spread, trading over 44,000 times for about 41 and a half cents, " "Options Action" trader Mike Khouw said Tuesday on CNBC's "Fast Money. "
"When you buy that put spread, you're obviously making a bet that [the XLF] is going to fall below that 27-strike price that you bought, and possibly down to that lower strike that you sold."
Since each put spread contract represents 100 shares of the XLF, the total cost of this trade ends up just under the $2 million mark. As Khouw points out, that means there are some interesting possibilities as to who put this trade on, and why they did it.
"If you happen to run, say, a $1 billion book, and you were looking to hedge your financial exposure, take a look at where these strikes line up. That essentially represents — from $24 up to about $26.50, where this would really kick in — the gains that the financials saw from the beginning of the year to the end of the first quarter," Khouw said.
"So it would make a lot of sense to me if somebody who was running a book of that size was looking to hedge the gains that they've seen in the financials, given the volatility that we're seeing right now."
Khouw also pointed out that this mystery trader is selling those 24-strike puts on the lower end of the trade for just 9 cents. Since those contracts are going for such a cheap price, it would seem that if a buyer thought the XLF was headed for a plunge, those would be worth owning, rather than selling.
Or so it would seem.
"Sometimes, if you have a really big position to put on — and this obviously represents over $100 million, notionally — one of the reasons you might sell those puts is that it actually helps you find liquidity in the marketplace," Khouw said. "If you're going to be a seller of this spread, you definitely want to be able to at least own that downside strike to afford some liquidity to the institutional buyer looking to put on a trade like this one."
Of course, once the trade is put on, this trader has a couple of decisions to make before the expiration of the contracts. Do they monetize the trade by selling the higher strike put, and use the premium to roll their position downward in anticipation of an even bigger plunge? Or do they hold onto it and use it in a more straightforward hedge of their long position in the financials?
"In a situation like this, where you own the spread," said Khouw, "this is really protection. You kind of have to hold this a little bit, because if it runs to $24 quickly — because this expires in June — you're not going to get the full value of that spread right away.
"When you put on a spread like this proactively, that's probably just looking to hedge existing gains, basically through the end of the current quarter that we're in."
The XLF was trading slightly higher Wednesday afternoon.