One of the more unusually active spots in the option market during Thursdays session was in the SPDRs Financial ETF (XLF ) with a busier-than-normal 507,000 contracts changing hands. Of that total, traders focused their efforts on the puts by a margin of nearly 8-to-1 over calls. Wow! or What, Where and Why?

Checking the board for further clues, the largest action concentrations of interest were in out-of-the-money July 13, 11 and 9 puts on net volume of nearly 160,000 contracts and almost 187,000 August 13 puts in an otherwise very quiet calendar month for trading. The spike in put activity while certainly large isnt without precedent and to take it purely at face value as the kind dominated by overt bearish wagering could be a mistake.

The reason we suggest throwing some caution to the wind is that as an incredibly liquid sector proxy for one of the markets most notorious and influential groups; the XLF is an instrument which can be targeted for hedging other portfolio bets in its more volatile names. You dont have to take my word for it, but we think youll agree this is a popular strategy if readers take the time to look at the put/call chart for XLF.

Shown below in Figure 1, its easy to see the bulk of trading in XLF typically favors its puts with readings common enough above 2. While company specific risk such as a Lehman Bros. or Bear Stearns blow up isnt removed, against XLFs very heavily-owned basket of underlying names; it certainly does the trick of acting as an effective hedge.

Figure 1: SPDRs Financial (XLF ) Put/Call Chart

Digging a bit deeper into Thursdays Care Bear cadre of activity, roughly half of Julys fore-mentioned put activity was put up 19,500 times as a 13/11/9 butterfly for $0.22 per spread according to Whatstrading.com. Spying slightly deeper, a similar closing ratio on those strikes makes that effort appear even more popular when all was said and done.

Technically speaking, it appears obvious this larger trader has at least some bearish affinity for the charts. The 11 strike put and where this strategy would enjoy its maximum profit potential of $1.78 is centered on the October lows. However, given shares are currently trying to hold 200SMA support near 13.75, theres nothing to suggest this same trader couldnt be using the position as a hedge.

For instance, while there would remain net long exposure below the downside breakeven, with going out of business gap risk essentially removed from the XLF itself, the butterfly could be used more effectively as a hedge against some amount of stock ratioed against the fly.

Figure 2: Long Butterfly with Long Ratio XLF Stock

Shown above in Figure 2, were illustrating a 20 x (40) x 20 long July 13/11/9 butterfly combined with the purchase of 400 shares of XLF. We see this ratio provides fairly strong protection all the way down to a retest of the October lows if shares were to suddenly drop in the very near future, but work their way into a profitable situation if the move dragged out into expiration. Only below the expiration breakeven of about $10 would the net long position be exposed to much larger downside risk.

As for the heavy August put action, 175,000 contracts in two prints for about $0.51 to $0.52 which apparently swept the contracts offer, accounted for more than 90% of the days volume. With lesser existing open interest, the assumption of an opening buyer certainly makes sense. There too though, theres nothing which says (and youd need carnal information from the trader to prove otherwise) the traders right to sell stock at 13 wouldnt gladly be forfeited for a move to the upside in the XLF or perhaps a basket of financials (JPM. MS. GS. and BAC ). And with those options currently priced for $0.46 and down $0.05 to $0.06, the potential damage to that portfolio remains to be seen.

Chris Tyler

Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate