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Traders turn to derivatives that protect against US market fall

Investors are increasingly turning to a tool to protect them if the US stock market careens lower in the coming weeks.

Traders are buying put option contracts in ever greater numbers, hoping the derivatives will provide a hedge if stocks fall from record territory. The rising use of put contracts, including by the swell of new retail day traders who entered markets this year, has accompanied a surge of volatility in the $53tn US equity market.

Stocks have whipsawed over the past month as traders have been confronted by the spread of the Omicron coronavirus variant, tighter monetary policy from the US Federal Reserve and the prospect that the White House’s flagship $1.75tn spending bill may stall in Congress.

This has pushed both retail and institutional traders to embrace put options, which can pay if a security falls in price. It is a noteworthy shift, particularly among retail traders who this year had been relentless buyers of call options — derivatives that can be profitable if a stock rises in value.

“When you have inflation, record high asset prices and rising interest rates, that makes for a pretty perfect storm for people wanting to buy a little extra protection,” said Tom Sosnoff, co-founder of Tastyworks, an online brokerage with hundreds of thousands of clients. “Any time you get to record highs people think ‘when is the shoe going to drop’.”

Column chart of average number of put options outstanding each quarter in the US (m) showing investors are turning to options markets to hedge themselves

While the S&P 500 has advanced by more than 27 per cent this year, setting a new record on Monday, those gains have not been evenly distributed and many investors who stepped in to buy on dips have not been rewarded.

More than 200 of the companies within the US equity benchmark are down at least 10 per cent from recent highs, with close to 90 of those S&P 500 companies off at least 20 per cent. That has been one signal for some traders that the “everything rally” is not as durable as many of the benchmark indices have made it appear.

Many of the meme stocks that rocketed into the stratosphere have also begun to come back to earth, including recent declines in GameStop and AMC.

Line chart of difference between number of US call and put contracts traded each day (m) showing the gap between call and put volumes has started to shrink

“Customers made a ton of money buying calls and speculating over the past year or two and now that doesn’t work any more,” said Henry Schwartz, head of product intelligence at exchange owner Cboe. “How many customers can successfully shift into strategies that will do well in a sideways or down market?”

Goldman Sachs strategist Vishal Vivek noted that single stock put options trading hit a record $353bn on December 3 and that average daily trading volumes of $233bn in November was an all-time high. Vivek added that the $217bn daily put volume average in December remained elevated “despite a decline in single stock call options”.

There are signs some of that buying is coming from retail traders. An increasing number of small-sized options trades, which investors have used as a gauge of retail investor activity, have been for those new put contracts. Jason Goepfert of SentimenTrader estimates that roughly 23 per cent of new retail options contracts opened in the week ending December 17 were for puts, up from 16 per cent at the start of November.

It places put activity more in line with how traders used derivatives before the surge of many meme stocks this year, when many new day traders had bet stocks could only go up.

“It’s a flexibility that people don’t think retail had,” said Peter van Dooijeweert, hedging specialist at hedge fund Man Group. “They think of retail as knee-jerk buy the dip call buyers. But we’re seeing that sophistication.”

Van Dooijeweert added that it was not simply retail traders turning to the options. Big money managers have also gravitated to put contracts, using them to hedge their portfolios instead of Treasuries, given the view that US government debt has little room to rally in the event of an equity market drawdown.

The number of put contracts outstanding has climbed by more than 25 per cent since the end of 2019, according to data from Cboe Global Markets and OptionMetrics. And there is a sense that even new retail traders are not exhibiting some of their old habits. When buying call options, the swarm of retail traders often opened and closed options trades on the same day, in a bid to profit on the price swings of the option as opposed to making a long-term call on the movement of the underlying shares.

While that has been partly true on the put side, strategists and traders said there were signs these small traders were also using the puts in the more traditional sense: holding puts to hedge against a sell-off.

“This market is killing me,” Reddit user ColdDonkey4784 wrote on the message board WallStreetBets. In a discussion about how to make profits — sometimes referred to as “chicken tenders” — using options trades, the person said: “I am a bull by nature. But I am happy to buy puts if it makes ‘tendies’.”

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