How to interpret Unusual Options Activity

How cool does this sound; imagine I walked up to someone at a party and told them “my trading strategy relies on Unusual Options Activity”. Probably make me feel like James Bond or at least some sophisticated business man. Most people think options are super complicated, and now we are talking about them behaving in an unusual manner! Give me a break!

In any case, Unusual Options activity can be a very powerful indicator to determine a price action trend or sentiment in the market, which if applied correctly can be very lucrative. However, the fact that an Options Activity is “Unusual” doesn’t necessarily mean anything in itself and is not necessarily an indication for anything. Unusual Volume will usually refer to the volume traded that day as a percentage of the average traded volume. Over 50% is considered unusual.

So, in order to interpret when we see an unusual contract for example; $500k Sweep Order on $100 Aug 21 2020 Calls for Stock XYZ, essentially we want to know if that order came through with a high conviction from the seller, or with a high conviction from the buyer (more factors would go into a more detailed analysis like exp date and strike price but for sake of time we will not go into that, just this main idea). 

Understand this;

  • If a call contract goes through with a high conviction from the buyer, then it is a bullish signal; on the other hand if it comes through with a high conviction from the seller it is not a bullish signal.
  • If a put contract comes through with a high conviction from the buyer then it is a bearish signal; on the other hand if it comes through with a high conviction from the seller it is not a bearish signal.
  • We are MOST interested, on those contracts that are coming in with a strong conviction from the buyer because it means they believe strongly in the performance of the contract (whether it is a call or a put).

The question then becomes, how can we identify whether the conviction is high on the seller’s side or the buyer’s side. The answer to this question is that we have to look at the price which was paid for the contracts, in particular if the price paid was on the ask or the bid.

  • Ask: a price which someone has recorded in the ledger they are willing to sell something
  • Bid: a price in the ledger someone has recorded they are willing to buy something

Lets say for example, I am bullish on a stock. I would go out and buy a call contract (I can buy at market, or place a limit order). However, if I am really bullish and do not want to miss out on the opportunity, I am not waiting around to get filled (especially with large orders) I am just going to go ahead and pay for whatever someone is asking at that particular moment. This means the contract got filled at the ask which is the lowest price that was advertised at that moment. 

It works the same for puts. If I really believe something will go down, I am just going to go ahead and buy the Put at the price that is advertised.

Now, if you tell me that there is unusual volume, and that volume is being bought at the ask, I can start to build a picture that someone has a strong inclination towards the contract they just bought. If it’s a Call, then bullish sentiment; if it’s a Put, Bearish sentiment.

There will be some people thinking about the Open Interest and if the orders were to Open or Close, but the truth is even if I bought a call to close at the ask, it is still bullish sentiment because I am closing out a bearish position. So we will not discuss this here (only in the comments for now ☺)

Lastly, we need to keep in mind that options can be used for hedging strategies as well as income generating strategies. (perhaps I sell a call to generate income, but I don’t believe the stock will go up, or I hedge just in case, but I don’t believe the stock will go down). So this is also important to keep in mind when looking at unusual options activitiy.

So in summary, to understand if the option was filled at the bid or the ask will give you more insight into what really did that trade mean, and when you start to cross that with other information such as strike price, expiration date, volume, open interest, news or earnings context, and technical indicators this can prove a very handy skill to have available in our toolkit.

Thoughts of a Psycho Trader… 

One last thing…. If this strategy is crossed with Dark Pool trades it can become even more effective and reliable for determining trends, and thus profitable trades before they happen. Let me know in the comments if you want an article about Dark Pool Trades.

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