With the stock market having fallen six weeks in a row and flirting with a possible seventh weekly decline, investors with a short-term mind-set are understandably getting nervous. But if you want to know which stocks have investors most worried, it's helpful to look at a gauge of sentiment that many people never look at.
Quick and easy portfolio protection
If you're convinced that a stock in your portfolio is going to drop, then the easiest way to protect yourself is simply to sell your shares. If you take the money and run, you don't have to worry about any further losses in the stock price.
But how often are you absolutely certain that your stock is going to go down? If you sell, then you'll miss out if there's a short-term rebound -- let alone the truly massive profits that may come over the long run.
In order to protect yourself against a stock decline without losing all of your potential upside, you can buy put options on your shares. Put options give you the right -- but not the obligation -- to sell your shares at a specified price within a certain timeframe. If the market price for your shares falls below that specified option price -- also known as the exercise price -- then you can exercise your option and get the higher payout. If shares don't fall below the exercise price, then you won't exercise the option, instead either selling your shares on the open market for a higher price or keeping them.
Put options are a lot like insurance. Moreover, by looking at the behavior of people buying put options, you can predict where everyone thinks lightning will strike next -- and then decide whether you think it makes sense to join them or take the contrary view.
So many puts, so little time
Every day, The Wall Street Journal publishes data on what it calls "unusual daily option activity" during the most recent trading session. By comparing that day's volume of put options traded against longer-term average put volume, you can see which stocks are attracting particular attention from those wanting insurance against a potential decline.
Here, for instance, are the top outliers from yesterday's trading:
Number of Puts Traded
Multiple vs. Average Put Volume
Research In Motion
|Market Vectors Gold Miners||61,577||3.1|
In some cases, it's pretty obvious why there's so much put option activity. In Harbin's case, the stock lost half its value yesterday on news of yet another report from Citron Research questioning whether Harbin's CEO will be able to complete a $24-per-share buyout bid. That news may have sent Youku down in sympathy, as the company has recently set new lows since going public late last year. Similarly, Finisar plunged after releasing poor earnings Wednesday night.
Sometimes, options activity picks up in advance of coming news. Research In Motion, for instance, released quarterly earnings after the market closed yesterday. That could well have prompted many to buy put protection before the announcement, especially in light of the stock's poor performance lately.
Yet it's often harder to figure out why put options become popular on certain stocks. Marathon, Vale, and the Market Vectors ETF share a common link to commodities, which have come under pressure along with the stock market during the latest round of Greek sovereign debt fears. But options activity sometimes precedes news that only later makes clear exactly what investors were fearing when they bought put protection.
Should you protect yourself?
Deciding whether to buy put options depends on a number of factors, such as the price of the option, the tax consequences of just selling your shares, and your risk tolerance. Puts are usually expensive enough to keep them from being a perfect solution, but to allay short-term fears, looking at put options might give you the confidence you need to stick with your longer-term investing strategy.
If you're interested in using options, learn more from our Motley Fool Options service. Simply enter your email address in the box below to receive a free copy of our "Options Playbook."