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.
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: