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Trader Resources

Learning About Options Trading

I had an email the other day asking me to point the writer in the direction of some solid options trading education, and potentially a mentor. Now, I can hold my own in most options discussions from a knowledge perspective, but I don’t have anywhere near the experience of folks out there with decades trading options in various fashions. The person who falls into that latter category that comes first to mind is Mark Wolfinger, who is a contributor to my Trading FAQs book.

Mark authors a website and blog called Options for Rookies. He’s written a couple of books on options trading and his experience in the markets. He’s also part of the team at Expiring Monthly: The Option Traders Journal. He knows his stuff and is very willing to share the knowledge and experience he’s picked up along the way. That’s why I asked him to take part in the FAQ project.

If you’re looking at learning about options and/or getting started in that market, Mark is a good place to begin.

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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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Reader Questions Answered

Exiting Option Trades

In keeping with the recent theme, here’s an option trading question I received over the weekend.

Hello John,

Your book is great and has helped me a lot. But now, I’d like to get more into options. As your book put it – put the pedal to the metal.

I’ve read a few books on options already. But, I have a problem. While they all go into the intricacies of what options are, the greeks, and some trading strategies, none of them really have a how-to aspect to it.

Specifically, I am looking for how to close out positions. It is easy to put on the trades, but I am not sure how to close them out.

For example, let’s say I buy a Feb call for XXX stock at $90. At expiration, the price of the stock is $100. So now, I’ve got a profit of $10 per share. In order to take advantage of that, do I have to actually take possession of the stock, then sell it on the open market?  Or is there an automated way to do this? Or do I just try to sell a call option and take the profit from there?

Or, even if the stock jumps to $100 a week before expiration and I want to take advantage of the $10/share profit, how do I do this?

Anyway, these are the types of questions that none of the books I have read seem to answer. So, my question to you is, do you have a book or a course that answers those specific types of questions?

Thanks very much.
Hector T.

There are two ways to close out a stock option position. Actually, there are three, but I won’t count letting an option expire since that really doesn’t require any action on the trader’s part.

Exercising the Option
One of the ways to close an option trade is to exercise the option, as Hector noted. That means telling your broker you want to do so. Using the above example of the XXX $90 call, exercising would me that you buy the stock from the option seller for $90. You can then sell that stock at the current market price, presumably making a profit.

It must be noted, however, that certain types of options only allow for exercise as specific times. An American style option has no restriction. You can exercise it any time from when you buy it right up to expiration. European style options, however, can only be exercised at expiration. There are also Bermuda options which have specific periods when exercise is permitted. They are a kind of blend of American and European.

It also should be noted that expiration doesn’t necessarily mean there’s no execise of the option you hold. In some markets if you hold an option to expiration you will automatically be exercised at expiry, if it’s in the money, unless you provide instructions otherwise. That means you’ll end up with an active position. Make sure you are aware of how expiration is treated in the market you trade.

Selling the Option
In most cases, exercising is actually not the best approach when you want to close out an option position. Normally, the best way to close a long option trade is to simply sell the option in the market, just as you would a stock position you were holding.

Consider Hector’s example again. If you were to exercise the call option and sell the stock for $100 you would make $10/share. That’s pretty straightforward. You would, however, have to take the cost of the option out of your net profit, so you would actually make something less than $10/share.

Now consider the price of the $90 option when the stock is trading at $100. It’s going to be trading at something greater than $10 because it has $10 in intrinsic value. How much above will depend primarily on implied volatility and the time left to expiration. That means you will end up with more bottom line profit if you sell the option than if you exercise.

To put that into numbers, assume you paid $1 for the $90 call. If you exercise the option you end up with $10 – $1 = $9 in profits (transaction costs aside). Now let’s look at selling the option. It’s going to trade somewhere above $10. Even if it’s just $0.01 higher, you still come out better off. Selling the option gets you $10.01 – $1.00 = $9.01 in profits.

Of course, if the option is out of the money, then exercising the option makes no sense at all because you’ll lose money on selling the stock in the market. There again, selling the option is the favored approach.