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Lack of Put Purchases a Concern

January 1, 2007

 

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This is an abbreviated sample of a comment posted for subscribers

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One of the simplest ways to hedge ourselves against a market decline (other than selling stock and putting the proceeds into a money market fund) is to buy a put option.

 

A put gives us the right, but not the obligation, to sell stock at a certain price at a certain time in the future.  If we think our stock might drop and we don't want to sell, then we can simply buy a put for protection.

 

Because it's so simple and straightforward, watching the how many puts are bought can be an effective way to determine how much investors are hedging their portfolios.  Lots of games are played by professional traders in the options markets, but what we're going to look at today are only those options that were bought as an opening transaction - increasing the chances that we're looking at hedging activity instead of one piece of a complicated overall strategy.

 

The chart below shows the number of put options that were bought, expressed as a percentage of total option volume.  The data includes information from all the major U.S. options exchanges and is the most complete picture available.

 

 

 

When the blue line crosses into the green highlighted area, we can conclude that traders are spending a good deal of their option money on hedges.  And, more often than not, that display of concern is unwarranted as stocks have had a habit of rising afterwards.

 

At the other end of the spectrum, when the hedgers stop hedging and the blue line enters the red territory, we can assume that optimism towards further gains is the norm - even though equities often struggle going forward.

 

Currently, we've been seeing a rapid lifting of hedges as investors just haven't seen the need to protect themselves.  With the rally of the past few months, there's little question why they feel that way, as their put purchases are acting like a parachute holding back their long positions.

 

While just entering extreme territory, this kind of behavior is enough to believe that hedgers are not hiding in the options markets.

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