More Investors Are Betting on Major Selloff in Stocks

Not everyone on Wall Street is convinced that the worst is over.

In fact, some investors are betting tens of millions of dollars that the market is headed for a selloff -- a major selloff.

The reason: worries about a worsening credit crunch, along with speculation that the Federal Reserve may defy expectations and hold off on cutting interest rates at its Sept. 18 meeting.

So far, over $500 million in so-called put options have been purchased betting that the benchmark Standard and Poor's 500 index will tumble anywhere from 5% to 11% in September. Some investors are even buying put options calling for 52% decline. A "put" option increases in value as the underlying stock or index falls.

To put it in perspective, a 5% drop in the Dow Jones Industrial Average would be the equivalent of 667 points. An 11% decline would equal 1,468 points. And a 52% drop? You don't even want to know.

The upshot is that some major investors are putting up big money that the market is facing a major decline.

"There is still fear and investors are buying crash protection," says Todd Salamone, senior vice president of research at Schaeffer's Investment Research.

Of course, there are always investors betting on big declines -- they're called bears. What's unusual is the amount of money being put up on such a doomsday scenario.

"The activity in those puts has been a lot more aggressive then we have seen in the past,"  said Bill Lefkowitz, options strategist at brokerage firm Finance Investments. "Part of it is the environment and volatility where the Dow Industrials can easily swing over a hundred points during the day, or session to session."

Salamone of Schaeffer's points out that the index options have been "put dominated over the last several months." And the bets may have as much to do with hedging portfolios -- basically an insurance policy you hope you don't need -- as much as outright speculation.

"We don't know who the end users of these options are and often they are specialists, pros looking at arbitrage plays, so the common man doesn't necessarily need to be concerned," adds Andrew Wilkinson, a senior market analyst at Interactive Brokers. "But it’s a legitimate build of people wanting protection against the next 10% down should it come."

Whatever the reason, Lefkowitz says worries about what the Fed will do about interest rates are spurring big investors to buy protection in case of a major market drop.

"If the Fed doesn't cut Fed funds, the options market is telling you that the overall stock market will come down hard," says Lefkowitz.  "We could be quickly under the 1400 level of the S&P 500 if the Fed doesn't act."

Fed-fund futures and a variety of market pundits have been forecasting a 100% likelihood the Fed will lower the benchmark lending rate, now at 5.25%, meaning there's no room in the market from the Fed for a surprise.

Lefkowitz also says the activity isn't strictly driven by money managers looking to protect portfolios. The put options are tempting enough for speculators to jump in.  He says even if the market doesn't fall to below S&P 1400, the put options could still easily rise in value by "20, 30, 40 percent if we saw another large down day."

© 2009 CNBC.com