In the past week, Rick’s Picks has been monitoring the put options of a stock that looks extremely vulnerable to an economic downturn. Because we are convinced the U.S. has already entered a recession, our goal has been to accumulate puts in this stock, and perhaps others in its group. Yesterday the stock took a dive near the end of the session, but the puts actually decreased in value. How can this be? someone in the chat room asked. 

In all too many instances such anomalies can be traced back to some sleazy brokerage firm that is front-running its own customers. For instance, if the firm has a customer who is trying to unload a million shares of XYZ stock, it might try to sell calls or buy puts ahead of the transaction. Sometimes the broker will do something even shadier, briefly bidding up the price of XYZ so that, with the million-share offer hidden from view, the stock looks stronger than it actually is. Then, with XYZ artificially pumped up, the broker will short a ton of calls, or buy a ton of puts, or both. That’s how money is made on Wall Street, folks.

(Click on table to enlarge)

But in the instance yesterday that some chat-room regulars found so baffling, there may have been no such skullduggery involved. The options in question were out-of-the-money puts with a strike price of 70. Notice in the upper right-hand corner of the table that the open interest in these puts is 24,628 contracts. That is far more than all of the other strikes combined, except for the 80 strike, in which there are 24,935 contracts currently in play.  Notice as well that puts at the 70 and 80 strikes traded almost identical volume on Tuesday -- a little more than 800 contracts, which was far more than any of the other series.

What this suggests is that, over time, two or more parties have been trading the heck out of this $10 vertical put spread (which closed yesterday at around $3). It is impossible to say how, or even whether, this position is being hedged, but the simplest explanation is that someone is buying insurance against a decline in the stock between now and January.  That doesn’t necessarily mean the put buyer is bearish, either. For instance, he might be arbitraging the puts against high-yield bonds issued by the underlying company. The possible explanations are too numerous to ponder, but suffice it to say, the mere fact that certain put options have acted in a “weird” way is not necessarily an indication that the underlying stock is about to do the same.