Reading Order Flow for Unusual Options Activity
By James Ramelli, AlphaShark.com
An option is a contract between the buyer and the seller. There are two types of options: calls and puts.
Calls give the buyer the right, but not the obligation, to buy a specified stock or financial instrument (the “underlying”) at a specified price (the “strike price”) on or before a specific date (“expiration”). The buyer has the right to buy the underlying at the strike price, and the seller has the obligation, but not the right, to sell the underlying should these conditions be met.
Puts give the buyer the right, but not the obligation, to sell the underlying at the strike price on or before expiration. Put buyers have the right, but not the obligation, to sell the underlying stock (or other instrument) at the strike price on or prior to expiration. Alternatively, put sellers are obligated to buy the underlying at the strike price should a buyer choose to exercise these rights.
So what factors determine how these options are priced? Six factors, or price inputs, determine an option “premium:”
- The stock price
- The strike price of the options
- The time remaining until expiration
- Interest rates
- Implied volatility.
In general, the more a given stock fluctuates in price on a daily or weekly basis, the more expensive its options will be, and vice versa. Options usually tend to be more expensive prior to earnings reports and other major announcements but decrease in price sharply after the announcement, once the “uncertainty” has been removed. A good example of this is biotech stocks and drug announcements.
Options are traded for one of two reasons: as speculation, or to hedge against a stock position.
Options are bought as a speculation that a stock will move in a certain direction. Calls may be purchased because a trader believes the stock will move higher prior to expiration. Alternatively, puts may be purchased because a trader believes the stock will move lower prior to expiration.
The terms “in-the-money,” “at-the-money,” and “out-of-the-money” are used to describe the relationship of an option’s strike price to the price of the underlying stock. A call is in-the-money when the stock price is above the strike price. Alternatively, a call is out-of-the-money when the stock price is below the strike price. As you might guess, if a call is at-the-money, its strike price is equal to the stock price.
The inverse is true when looking at puts: if the strike price is above the stock price, a put is considered to be in-the-money. A put is out-of-the-money if the strike price is below the stock price, while the at-the-money definition is the same as for calls.
Options are also purchased to hedge against stock positions. Each day, I watch over 2,000 trades in real-time as they hit the tape. I always try to determine, are these orders a hedge against a stock position, or a speculative play? In the eleven years I spent trading on the floor, I learned how to “Read the Tape.”
Most certainly a combination of art and science, it is a skill I’ve honed over the years. A large part of my trading strategy is based on my ability to do this. By watching for big block option orders, dubbed “unusual options activity,” I try to determine the positions of Paper. “Paper” is term originating from the trading floor, when orders were actually written on paper and run to traders in the pit by clerks. It is used to describe large institutions such as hedge funds, mutual funds, or large banks. In other words, institutions who have access to better information – even “insider” information – than your average trader or investor.
When trading off of unusual option activity, I only want to take trades based on orders I believe to be speculative plays. Given the sensitive, and even illegal, natures of their positions, hedge funds tend to be a secretive bunch. Thus determining if these trades are speculative or a hedge is like piecing together a puzzle.
Let’s put it another way: what if you could have taken the same trades as Raj Rajatnam, or SAC Capital’s Steve Cohen, the moment they were put on? I’d go to jail for insider trading, you might say? Not so fast.
The moment an order hits the tape, it becomes public information. I can trade off it, based on the fact that I believe someone placing such a large bet has access to insider information, and it is completely, 100% legal. This isn’t a matter of debate, or speculation, ask any SEC lawyer you know. This is why I trade unusual options activity. And this is why it works.
The Unusual Options Activity Trading Plan
There is no secret to becoming a profitable trader, and you should be skeptical of anyone who tells you otherwise. That being said, the techniques I’ve outlined in this text served me very well in my trading career and without them I would not have made the money I did.
Reading order flow and watching unusual options activity continues to be one of my most profitable techniques, just like it was on the trading floor. I had two very profitable years in Apple stock when my net profits in AAPL were over a million dollars. Once a week for a year, a Merrill Lynch broker would walk into the pit and sell AAPL put spreads. His acronym was “HES,” and whenever I would see him coming, I would know to get long and sell volatility. How did he know? No clue, but by watching him I made quite a few profitable trades.
By combining order flow with technical indicators like the Ichimoku cloud, I devised my OCRRBTT trading plan to trade profitably off of the floor.
The OCRRBTT Trading Plan
Pronounced “Oak Ribbit,” this trading plan will give you a step-by-step method for breaking down unusual option activity. After evaluating unusual trades with this plan, you will be able to decide if you want to follow it or ignore the trade altogether. The letters in the acronym stand for:
- Open interest
Here you will see the importance of each of these elements in the plan.
Open interest: The first thing you need to look at is if the trade volume is bigger than the current open interest in that line. If it is, this means that this is an opening position and is worth taking a look at. You don’t want to buy an option on unusual activity if it is really just paper covering a short. Only consider trades where volume is greater than open interest.
Chart: This is the second most important element of the plan. Once an unusual order is confirmed to be an opening order you must then look at the chart of the underlying stock. You need to ask questions. Is the stock in a strong bullish or bearish trend? Is there support or resistance at the strikes the institution is trading? Is it more likely they are speculating on more upside or downside or could they be hedging? The answers to these questions will help you determine if the trade is speculation or a hedge. This will keep you from trading against the institution when you actually want to trade with them.
Risk, Reward, and Breakeven: Once the direction of the trade is determined, you have to evaluate if the risk vs. reward profile of the trade the institution executed is in line with your risk tolerances. Some trades they take could be far too risky for the average retail trader. However, since you know the direction the institution is betting, you can tailor a trade that has the right risk setup for you. The risk of each trade must also be measured against the potential reward. If the institution is risking $5 to make $1, this is a trade you would want to avoid. You should also always be aware of the breakeven of each trade. If there is significant support or resistance at the breakeven point, you may want to consider another strategy.
Time and target: Always be aware of potential catalyst events that might be near. You want to know if paper is playing the overall direction of the stock or if they are playing a near-term catalyst event like earnings, drug announcements, or new product launches. This might factor into your decision to take the trade or not. Once you have your time horizon set, you want to pick a profit target. Are you leaving this trade on to expiration? Taking off half at a double and letting the rest ride? Knowing the answers to these questions at the onset of the trade make it easier to manage going forward.
Putting the Plan to Work
Once a trade hits the tap, a trader must use the OCRRBTT trading plan to analyze the setup and determine if it represents an actionable trading opportunity. Let’s look at the example below and determine if it is a trade setup that we actually want to take. This order hit the tape on June 16th 2015.
Before running this trade through the plan, we need to understand the information we have.
We are able to get a lot of information from order flow. We can see how many contracts this trader bought, that it was a $540,000 bet and that the trader that bought these options paid through the market maker’s offer to get filled. Although all of these things make this trade interesting, they still do not necessarily qualify it as an actionable setup.
To make this determination, we must evaluate this trade using the OCRRBTT trading plan.
Open Interest: Was this an opening position? This trade is labeled opening, so there is no doubt it was an opening position. If for some reason the trade was not labeled opening, we would still be able to confirm that it is because the volume of 5,000 contracts is greater than the current open interest in the line of only 796 contracts. With open interest smaller than volume, there are not enough open contracts in the line for this to be a closing trade. It is confirmed opening.
Chart: Does the chart indicate this trade is more likely to be a hedge or a speculative bet? We need to confirm that the underlying trend of the stock supports this as a speculative bet. If it does not, the trade may be a hedge, and it is less likely to be actionable. To do this, we will use an indicator called the Ichimoku Cloud. It may look intimidating, but for this purpose a trader only needs to know that anything trading above the shaded area on the chart is in firm bullish territory and anything below it is in bearish territory.
Here is the chart of CAG on the Ichimoku Cloud the day these calls hit the tape:
We can see that the stock is trading above the Ichimoku Cloud and is in an established bullish trend. This does not confirm with 100% certainty that this order was indeed a speculative bet, but it makes it far more likely that this is the case. With the trend supporting the idea of this trade as a speculative bet, we will move on to the next part of the analysis.
Risk and Reward: Does the potential reward justify the risk? This is a very large trade in what is generally a boring stock. ConAgra (CAG) doesn’t usually get much unusual activity, so if the risk and reward setup makes sense, it might be a trade that we want to take. This is an outright call buy, and a trader knows that they can never lose more than $1.08 in this trade. This translates to $108 in risk per one lot with what is a technically unlimited upside reward potential. This sets up for a good reward-to-risk setup, and a trader can take this trade.
Breakeven: Where is the breakeven point in this setup? These options are just out of the money and are being bought for $1.08. At that strike price, this trade’s upside breakeven is $40.08, or about 4.6% higher than the stock’s price at the time of the trade. This is only a 4.6% move to the upside. That is not an unreasonable move. With that in mind the setup becomes even more attractive.
Time and Target: What is the trader expecting? In this trade, they are looking for a move to the upside of at least 4.6% by July expiration. Since the trader bought the July 39 calls, we will buy the same ones. A trader should never trade a different expiration or price target than the institutional trader. Remember, they have better information than us.
Everything about this trade sets up well. All of the evaluations in the OCRRBTT trading plan point to this being an actionable trade setup.
This trade ended up being a fantastic winner. The trader’s motivations behind this trade become much more clear three days later when news breaks of activist activity in CAG.
Look at how the stock responded to the news:
The stock gapped to the upside and these options exploded in value. Anyone looking at the reaction in the stock might be surprised by the huge move to the upside, but those paying attention to unusual options activity were alerted to this potential move three days before it actually happened.
The options that the institutional trader bought saw an enormous move to the upside, trading as high as $6.20 before expiration. This means that at the highs, this trader would have profited $2.56 million dollars at the highs. Look at a chart of the options below.
A retail trader who followed this trader with a 20 lot of these options would have profited $10,240 at the highs. This is a perfect example of how a retail trader can harness the power of institutional order flow and trade more like the biggest and most successful hedge fund managers in the world.
How Can AlphaShark Trading Help Me?
Since founding AlphaShark Trading in February 2012, I’ve been overwhelmed by the positive feedback and response I’ve received. Business is booming, which is great, because I love helping traders improve their P&L through setting up better risk-versus-reward trades. Every day in the office, the other traders and I discuss strategies, options set-ups, and reasons why we did or didn’t take certain trades. AlphaShark trading began as a blog, but I realized I wasn’t just content with sharing my market commentary. After all the monetary success options brought me, I wanted to help others stop losing money at the very least.
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