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Guest Posts Trading Tips

Using Unusual Options Activity to Predict Large Stock Moves

Options have become an increasingly larger focus among stock market traders of late. Recently a question came in from a reader asking “How true is it that this can be used as a leading indicator of underlying stock price movement? Where can this information be found?” My colleague Joe Kunkle focuses a lot on options trading, so I asked him to provide his thoughts.

Along with the use of technical, fundamental, event driven, and other types of analysis, one of the best indicators of future stock price movements is to follow the “smart money”. One of the easiest ways this can be done is by focusing attention on unusual activity in the options market. Many contend that the options market is where the smartest traders are because of the ability to use leverage and the ability to take huge profits with minimal investments.

I will try and explain this, assuming a basic knowledge of the options market and the coinciding vocabulary.

Spotting Unusual Option Activity
Without getting too in-depth, the way to spot unusual activity is through the comparison of call/put volume versus average daily trading volume. There are many web-sites that provide this information for free, and I will list them later. However, simply looking at volume is not all that it takes. I tend to compare the volume in a particular contract versus the prior open interest. If the volume exceeds the open interest you know that new activity (as opposed to closing open positions) is flowing into the contract, and traders are taking their bets. You can also see if the volume was new by looking the next day to see the change in open interest.

A second way to come across unusual options trading is through a backward induction process. Basically, if you see a stock trading heavy relative volume or moving an unusual percentage amount, check the options in the front two months to see if anything catches your eye, and go from there.

Another important aspect is looking for large lots (or blocks) of contracts that are purchased and the time of purchase, and www.LiveVol.com is a very useful tool for this, albeit a 15 minute delay. Large blocks often symbolize that large institutions are trading, and not just every day retail investors.

Is it Option Buying or Option Selling?
Now, once you find the stock trading unusual options volume, and have identified the contract where the “action” is, the next step in the process is to see if the activity is opening buys or sells, and this can be tricky especially with options trading tight spreads. The way this can be done is to look at the Bid and the Ask on the contracts and watch to see where the last trade (paying close attention to trade size) price is, to see if traders are aggressive is selling the option (hitting the bid) or buying the option (willing to pay the offer).

After that step you should have a good idea of what traders are betting on, as for movement in the underlying stock. I personally pay attention to the front 2 months of trading, but some people find success looking further out as well.

News, Events, Data
There is usually a reason for the unusual options action, so pay attention to news releases and upcoming events such as earnings, FDA meetings, investor conferences, etc. I like to combine some technical and fundamental analysis to try and explain the options positioning to see if it looks to be a good bet.

Implied volatility, which can be added to your basic stock charts, will also show when investors are expecting large price movements, and you can use the price that the at-the-money straddle is pricing at to determine the anticipated move in the underlying shares.

Additional Considerations
This method of trading is not sure-fire, but has provided me with some blockbuster trades. In the last year I have been able to predict the demise of multiple financial stocks: State Street (STT), HSCB (HBC), Wachovia (WB), Prudential (PRU), Hartford (HIG), Citi (C), Lehman (LEH) just to name a few. Takeovers like Omrix (OMRI), UST (UST), Corn Products (CPO), Terra (TRA) and many more, the fall-out of the Rohm and Haas (ROH) deal, and various large movements from earnings and guidance announcements have all been spotted ahead of time from the options trading.

One final note: Be Careful and look at the full Options Montage to see if the trading volume is part of a spread trade, a complex strategy, a rollover, etc. This part takes some practice, but identifying call and put spreads becomes easier through time, by looking for eerily similar volumes in various strikes. Also be wary of the intraday stock chart checking for large block trades that could be part of an options strategy, as a hedge (such as a collar trade). Lastly, pay attention to ex-dates on dividends because sometimes heavy option flow comes in for dividend stripping, a strategy for later discussion.

Helpful Option Tracking Tools
Now that I have given you some of the secrets to this method of investing I will provide you with some tools to get started. Before that, please note that I provide analysis of the options market, and highlight anywhere from 10 to 20 trading opportunities daily, along with color regarding not only what is trading and who is trading it, but also why it is trading. I will soon be launching my own site (blog) at www.OptionsHawk.com where I will provide this analysis daily, and the site is currently under construction.

Finding Unusual Activity:

Looking at Historical Options Activity and Average Trading Volumes:

 

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Guest Posts Trading Tips

One Trader’s Path – Guest Post

One of my list members answered the call to contribute some thoughts on trading and trader development to share with others through a guest post. He’s asked to remain anonymous. I think it provides a fantastic perspective on what it really takes to become a successful trader – hard work and experience.

It took me many years and thousands of hours of market watching to develop my proprietary trading methodology. The baggage from my old “learnings” was so heavy that I was unable to trade successfully until I got rid of it. Then I stopped trading for about two years to get rid of bad habits.

There is always a price to pay for education. For some it may be losing several accounts, for others it may be hiring a good mentor to teach them; for me it was the school of hard knocks and even living at the border of impoverished conditions in order to study the market, back-testing and forward-testing several trading strategies until I finally developed a proprietary trading methodology that gives accurate entry/exit signals with levels for stop loss and profit targets. It was back tested with 5 years of data, forward tested in a virtual account successfully for six month and I am currently forward testing it in a live account.

Success comes with knowledge. Knowledge comes with experience. Experience comes with time and hard work.

I believe that one needs one good trading methodology to enter a world that no one ever really sees until you are there yourself. I am determined to enter this world this year and I will be happy to take many with me, if they so choose. I am taking baby steps toward that world and it is a great feeling.

I definitely don’t know everything. In fact I know very little and I am finding out the longer I live the less I know. I do make mistakes like everyone else; but I learned to quickly correct them with no ego involvement. Hesitation has little reward in life and none in trading.

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Guest Posts The Basics

The Great Manic Depressive: The Markets

The markets are a lot like a manic depressive in that there are moments of incredible euphoria and then, almost in the blink of an eye, incredible feelings of despair and hopelessness. These emotional extremes are also contagious to those who are participating in the markets and as individuals suffer these extremes they eventually reach a point where they are paralyzed into inaction just as the markets begin to turn in their favor or detriment.

When the markets are healthy and the future for the economy looks bright the market is incredibly euphoric and like a manic depressive experiences incredible highs in emotional well-being that often result in caution being thrown away while riding the incredible sense of euphoria as the markets rise ever higher. Unfortunately, as night follows day, markets will eventually go down but the investors swept up in such a strong emotion as euphoria feel too connected to its source (the market rising) to ever consider that it may be time to lock in gains or protect a position. They are blind, like addicts that cannot admit their addictions they cannot admit that now is the time to leave the market for that has become there drug of choice.

After awhile, however, as the emotional high subsides in the market and suddenly it crashes as it discounts the future of the economy which faces a slow down or recession which causes an ever increasing sense of despair and hopelessness among the investors as they hold on during every decline and hope thru every short term rally only to feel there emotional well-being crash lower as the decline continues. The markets become more and more depressed to the point of no return for the investing faithful who have been bleeding losses since the crash and, in there final act of their investing death thro, they liquidate their holdings for a fraction of what those holdings were once worth.

The last of these sellers often result in a climatic sell off resulting in sharp move down in the markets as a violent convulsion down squeezes out the last of the investors that had been holding on. The market stands at the abyss on death’s knell causing much of Wall Street and Main Street to feel the dull pain of impending death of what they have understood to be modern day capitalism. Doom and dread is everywhere….on TV, cable financial news, in the newspapers, in the classrooms, on the cover of magazines, and in every barbershop and hair salon everyone talks of the end of the markets.

Then, as the last of the sellers receive their stocks sell slips a stirring begins again in the markets. Suddenly, volume begins to pick up and a huge rally takes place but is discounted as short-covering by the short sellers. A few days later, another rally takes place on higher volume and again is ignored. New stock leaders begin to see new levels of volume pour into their shares as big institutions and money managers begin to take positions but, still, the individual investors stay away out of fear.

Over the coming months, the pessimism of Wall Street gives way to caution with all the talking heads giving glowing commentary again about the huge prospects for the economy and hot IPO’s (initial public offerings). Institutional money is still pouring into new leaders in the stock market and smaller investors begin to wonder if the rally is for real. Those that do decide they will participate but only when stocks “get a little cheaper” but they never do.

Soon, the new leaders are rocketing higher and higher while investors feel they are missing the boat and begin to buy without noticing that the general market appears to be stalling and coming under distribution. A few weeks later, as investors are now back in the market the market appears to decline again with investors caught in the crosshairs again.

This cycle is played out over and over again as the general market’s manic condition creates an emotional whirl storm that investors get caught up in and allow themselves to become victim to.

Average investors allow themselves to fall victim to this cycle of extremes because they come into the market with no plan or method to trade. They buy on tips from there brother-in-law or because a stock is reputed to be a “good company”. These are not plans or methods they are gambling.

A fundamental key to winning then is to realize that successful trading is counter-intuitive compared to how the general public approaches the markets. Having a method or system that allows you to exploit an advantage helps but, ultimately, even the greatest trading method ever devised helps no one trade successfully if they don’t realize there are certain underlying truths to making big gains in the market that are counter-intuitive to the way most people attempt to win at trading.

Now, that you can see a little how these cycles form and are repeated we will journey together to learn how not to be swept up in a tsunami of negative emotional turmoil due to unnecessary losses by following the crowd and/or our own faulty reasoning in future posts.