A major change has occurred in how some investors react to sharp, volatile stock market declines.
Rather than simply rushing to buy S&P 500 index put options to hedge their stock portfolios, investors are now increasingly selling puts when their favored stocks decline. (A put sale obligates the seller to buy shares at a set price within a set period.)
Put selling always increases in downturns, but it has occurred in such large amounts during recent routs that it has stood out from the tens of millions of options that trade each day.
During recent major declines— and especially on Monday —there was major bullish put trading in many stocks. Susquehanna Financial Group has highlighted this activity in market favorites including Amazon.com and Nvidia, as well as in such names as Target, Uber Technologies, Warner Music Group, Albemarle, Citizens Financial Group, Chevron, Halliburton, and PayPal Holdings.
The recent popularity of put selling during big stock declines suggests that a strong ribbon of support exists in the options market just below the stock market’s surface.
The sale of puts is bullish because it means investors are agreeing to buy stocks at lower prices. It also demonstrates that investors are increasingly savvy in how they “buy the dip” when stocks decline.
The traditional way to buy the dip is to buy shares when stocks are declining. By selling puts, investors get paid by the options market to buy stocks at lower prices.
If the stock bounces higher after the decline, and is above the put strike price at expiration, investors keep the money they received for selling the put.
If a stock is trading at, say, $50, and an investor sells a September $45 put for $1, the investor is obligated to buy the stock at an effective price of $44 ($45 strike price minus the $1 received for selling the put). If the stock is above $45 at expiration, investors keep the put premium.
For decades, investors have largely done the opposite. Major declines inspired hordes of panicky investors to primarily buy puts on the S&P 500 to hedge their exposure. During big declines, skittish investors are usually “price insensitive”—options market shorthand indicating that pessimism is so extreme that it is bullish for stocks, because investors would pay any price to hedge equities.
Investors still bought an extraordinary amount of defensive index puts to hedge Monday’s decline, but so much individual stock put selling occurred as to suggest a major behavioral change.
After decades of wasting money on high-price index puts—because stocks generally bounce back—some investors have seemingly learned that it is better to monetize the fear of other investors.
The great risk hinges on how investors finance their put sales. If they are financed on margin—that is, by borrowing money from brokerage firms—the absence of a snapback rally could spark chaos. Investors would receive margin calls and need to raise money to cover their puts. If not, the put positions would be shuttered by brokerage firms, which could exacerbate the stock market’s weakness.
If the put sales are cash-secured—meaning investors deposited money in brokerage accounts to buy stock before selling puts—the risk is likely muted because leverage would be minimized.
The broad embrace of put selling likely reflects generational changes. Many investors don’t remember a time when buying the dip hasn’t made sense.
At some point, the put-selling strategy will encounter a defining moment. Stocks won’t quickly retrace their losses and surge higher, as many investors have long experienced. When that happens, it will be terrifying—and that will determine if put-selling is more of a stabilizing force or a limpet mine below the stock market’s surface.
Corrections & Amplifications
If a stock is trading a $50, and an investor sells a September $45 put option for $1, the investor is obligated to buy the stock at an effective price of $44. An earlier version of this column incorrectly used a September $45 call option in the example.
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Originally Posted August 7, 2024 – There’s a Smarter Way to ‘Buy the Dip’ Next Time
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