Option trading volume has been hitting record levels driven by new, highly engaged retail traders playing the meme names. Top companies such as Gamestop (GME) and AMC (AMC) have seen over 2 million options contracts in a single day — making them the second and third most active options behind only the S&P 500 (SPY).
I’m sure many of you have read books, been solicited by newsletters, or seen the guys with ponytails on CNBC claiming they have a proprietary system for identifying and profiting from ‘unusual’ option activity.
Last week, they went so far as to say the activity in AMC was unusual on a day the stock nearly doubled and traded over 700 million shares. Of course, it was “unusual,” but helpful? to a task.
Using options trading activity as an indicator for impending price moves is difficult, subjective, and unreliable. That said, it can help confirm other indicators and increase the probability of a profitable trade.
Indeed, there have been many situations where activity in the options pits accurately predicts or presages an impending price move. There are two typical approaches: as a contrary indicator, or as a predictor.
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 put/call ratio spike or the Volatility Index (VIX) — to flag a market bottom.
The predictive approach toward options activity says this information may 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 options volume is that, for every buyer, there’s a seller. It’s therefore important to decipher the trade initiator. 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, indicating the activity is a new position rather than a liquidation. Also, be aware if there’s an impending known news event — i.e. earnings or a regulatory ruling — which could be causing the speculation.
Ensure 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 is 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 institution buying rather than retail traders. The former tend to have better info than the latter. If it’s institutional buying, it tilts the trade toward being “smart money.” If it’s the latter — 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’s also some software and services that get trade data directly from the exchanges that can provide a real-time stream of options transactions, including the number of contracts, price, and whether it’s spreads or tied to stock. Such services can be fairly expensive running $3,000 to $5,000 a 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 leverage options. Although options have an unlimited supply, unlike stocks that 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. In other words, they’d be selling calls to facilitate the transaction and immediately hedging or offsetting their position through the underlying stock to remain delta neutral. In that case, most of the options volume would be focused in a single strike. But, if the market makers believe the buyer has good info instead of hedging in the stock, they might buy other options, create a position with a positive gamma, and you’d see activity spillover into other strikes.
A Lot Going On But Nothing to See
Technology has made the job of identifying unusual activity a lot easier. But, its application is much more difficult. Electronic trading allows parties to execute a fairly large option order quickly and, more importantly, anonymously – particularly if they’re 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 to 30 or 40 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 try honing in on what’s truly notable rather than something that’s simply unusual.
There’s nothing wrong with tracking and trying to trade off big surges in options volume if it’s truly ‘unusual.’ Just be aware most cases won’t pan out.
Note: This article originally appeared at Option Sensei. The author is Steve Smith.