By: Steve Smith
You’re about to be overwhelmed with reports of ‘unusual options activity” as earnings season kicks in. But, don’t be duped. Most unusual activity can be ascribed to a rational reason, not some ‘smart money’ front running and placing big bets on out-of-the-money lotto tickets.
Earnings360 just kicked off and our first Q2 trade was a Johnson & Johnson (JNJ) bullish pay, which returned a quick 78% overnight. And yes, there was above-average option volume this morning. However, I wouldn’t call it “unusual.” The stock had earnings, started lower, and then shot up to a new all-time high. News and action like that tend to swell option activity.
Using options activity as an impending price moves indicator is difficult, subjective, and unreliable. That being said, it can help confirm other indicators and increase the probability of a profitable trade.
Indeed, there have been many situations where options activity accurately predicts or presages an impending price move. There are 2 basic approaches: a contrary indicator, and a predictive.
Contrary readings are predicated on the belief that prevailing investor sentiment is often wrong. Buy and sell signals are usually generated when readings hit extreme levels, such as a put/call ratio spike or one in the Volatility Index (VIX) to flag a market bottom.
The predictive approach toward options activity says that this info may reveal what the “smart money” is doing. Using options as a predictive indicator is more effective when applied to individual issues, rather than to broad indices or the whole market.
Here are some basic criteria for identifying meaningful activity and avoiding the chase for an activity that ends up being useless noise.
Volume and Volatility
One of the first obstacles to interpreting unusual options volume is that, for every buyer, there’s a seller. It’s therefore important to decipher who initiated the trade. This can usually be determined by looking at the time and sales data. If most of the volume was done at the offer price rather than the bid, it’s safe to assume the buyer initiated the trade.
Look for increases in trading activity and open interest. More specifically, the average daily volume should be at least 3x, focused on near-term options and 1 or 2 strike prices. It should exceed the prior open interest, indicating the activity is a new position rather than a liquidation. Also, be aware if there’s an impending known news event, such as earnings or a regulatory ruling, which could be causing the speculation.
Make sure the volume isn’t the result of a spread trade — the simultaneous purchase and sale of similar options that have different strike prices or expiration dates done — in conjunction with stock. A spread or buy-write is much more neutral trades than the outright purchase or options sale. Checking times and sales of various strikes with similar volume will reveal if these trades are outright purchases or part of a spread.
Next, look at the size of the transactions; if the volume is done in large blocks of 100-plus contracts, assume it’s an institutional buying rather than retail traders. The former tends to have better info than the latter. If it’s institutional buying, it tilts the trade toward being “smart money.” If it’s the latter (a bunch of 10- and 20-contract trades) it may be nothing more than people following a newsletter recommendation. Then, as the volume hits the unusually active list, you’ll get more people jumping on the bandwagon, and it feeds on itself. Those trades usually don’t work out.
There are also some software and services that get trade data directly from the exchanges, providing a real-time stream of options transactions including the number of contracts, price, and if it spreads or is tied to stock. Such services can run from $3,000 to $5,000 monthly.
The implied volatility, or option value, should increase even if the price stock doesn’t. This indicates that the buyer doesn’t mind paying the extra $0.10 or even $0.20, which on a $1 item, is a significant percentage premium to gain options leverage. Even though options have an unlimited supply, unlike stocks that have a limited number of shares, if demand is greater than the desire to sell then the price will increase.
Look for spillover into other strike prices. Market makers typically take the other side of the trade — that is, they’d be selling calls to facilitate the transaction and then immediately hedging or offsetting their position through the underlying stock to remain delta neutral, and most of the options volume would be focused in a single strike. But, if market makers believe the buyer has good info instead of stock hedging, they might buy other options. This can create a position with a positive gamma, and you’d see an activity spillover into other strikes.
A Lot Going on But Nothing to See
Technology has made the job of identifying unusual activity a lot easier. However, its application is much more difficult. Electronic trading allows parties to quickly execute a fairly-large option order and, more importantly, anonymously – particularly if they’re privy to, or have a hunch about, an impending price move.
In the past, when orders needed to be worked in person on the trading floor, it took longer to execute the transaction, and it was transparent as to who was doing what.
Now, with intraday activity disseminated in real-time, there’s both basic software and a multitude of sites and services that track trading volume and volatility. The result is the list of names with “unusual activity” that can run to 20 or 30 a day.
Clearly, the majority of these instances will prove to not be predictive or produce profitable trades. That’s why it’s important to try honing in on what’s truly notable rather than something that’s simply unusual.