Reading Options Activity for Future Moves
Unusual activity may be perfectly normal.
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Using option activity as an indicator for impending price moves 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 in which activity in the options pits accurately predicts or presages an impending price move. There are 2 basic approaches: as a contrary indicator, or as 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 spike in the put/call ratio or the Volatility Index (VIX) -- to flag a market bottom.
The predictive approach toward options activity says this information may actually 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 market as a whole.
Here are some basic criteria for identifying meaningful activity and avoiding the chase for activity that ends up being useless noise.
Volume and Volatility
One of the first obstacles to interpreting unusual option 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 an increase in trading activity and an increase in open interest. More specifically, the volume should be at least 3 times the average daily volume, focused on near-term options and 1 or 2 strike prices. The volume should exceed the prior open interest, which indicates 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 are much more neutral trades than the outright purchase of options. 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 being done in large blocks of 100 contracts or more, one can assume it's an institutional buying (or Lenny Dykstra), rather than retail traders. The former tend to have better information than the latter. If it's institutional buying, it tilts the trade toward being "smart money."
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