Why Are Traders Buying So Many Puts?

08/21/2009 10:18 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Investors, especially institutional investors, tend to use options as a way to control risk just as much as they use them as a way to speculate and make profits. In particular, put options are a very effective form of "insurance" against downside movement in the markets. Right now, investors are buying almost 50% more puts on the market indexes, such as the S&P 500 (.INX) and the Dow Jones Industrial Average (.DJI), than call options. This is a bearish sign. The put/call ratio has not been as high as it is right now since August 6, when the stock market started consolidating at the S&P 500's resistance level of 1,000.

Buying a put gives you the right to sell a stock or ETF at a specific price in the future. If you owned a stock and bought a put, you are essentially buying the ability to sell the stock for the put's strike price no matter how far it may drop.

Buying put options as insurance is expensive, but if the upside potential of the stocks you own is greater than the put's premium, then it may be worth it as a way to prevent large losses if the stock suddenly declines. As you can imagine, when traders start buying more puts than calls, they are probably concerned that insurance against the downside is necessary.

By John Jagerson of LearningMarkets.com

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