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How to Read Truly Notable -- Not Just Unusual -- Option Activity

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Here are some basic criteria for identifying meaningful option activity -- and avoiding the chase for activity that ends up being useless noise.

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Using option activity as an indicator for impending price moves is difficult, subjective, and unreliable. However, 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 two basic indicators/approaches: contrary and 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 (INDEXCBOE:VIX) -- and flag a market bottom.

Predictive readings say that 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 option 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 understanding 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 three times the average daily volume, focused on near-term options and one or two 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 or sale 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." If it's the latter -- that is, 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 programs and services that get trade data directly from the exchanges; these can provide real-time streams of option transactions, including the number of contracts, price, and whether they're spreads or tied to stock. Such services can be fairly expensive though, running $3,000 to $5,000 per month.

The implied volatility, or value of the option, should increase even if the stock price 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 the leverage of options. Even though options have an unlimited supply, unlike stocks which have a limited number of shares, if demand is greater than the desire to sell, then 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 option volume would be focused in a single strike. But if the market makers believe the buyer has good information, instead of hedging in the stock, they might buy other options. This can create a position with a positive gamma, and you would see a spillover of activity into other strikes.

A Lot Going On, but Nothing to See

Technology has made the job of identifying unusual activity a lot easier but applying it much more difficult. Electronic trading allows parties to execute a fairly large option order quickly and, more importantly, anonymously -- particularly if they are 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, not only did it take longer to execute the transaction, but it also was transparent as to who was doing what.

Now, with intraday activity disseminated in real time, there's not only basic software, but 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 up 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 hone in on what's truly notable rather than on something that's simply unusual.

Twitter: @steve13smith

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No positions in stocks mentioned.

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