How To Profit From Abnormal Option Volume
In this article we’re going to take a close look at how sudden changes in options volume under the right conditions can tip you off to some potentially explosive moves in individual stocks. Sometimes these moves are quite spectacular and you can see a stock pop 5%, 10%, 20% or more in a just a few hours of trading. But right off the bat, it’s important to state that these scenarios don’t happen all the time and the strategy we’ll be discussing in this article is a high-risk one.
Options volume is one of the keys to finding stocks that might possibly make these types of moves. To understand the logic behind this approach, you must understand that these moves are generally accompanied by news.
And not just any type of news. As you might guess, a move of explosive magnitude is going to be fueled by news whose perceived importance is of a similar magnitude. Generally this is the type of news that strikes at the heart of a company’s future prospects for growth and profitability.
Here are types of news items that can generate such wild action:
- Earnings substantially better or worse than Wall Street expectations
- New revolutionary technological breakthroughs or products
- Better- or sooner-than-expected results from an ongoing product or service . . .and the crown jewel of them all:
- A takeover announcement
Now here is where options volume comes in.
It is often the case that, prior to announcements like these, we can detect sudden surges in options volume that fit a certain quantitative profile. We can speculate all day long about who the buyers are and how they know what they know. . .but that is not our concern. The important thing to know is you can the use Options Alerts in TradersWire to help you identify stocks which may move in response some earth-shattering news not yet public.
Before we go on, let me explain an important caveat. When you see a spike in options volume, you do not know why a particular individual has suddenly committed thousands of dollars to an out-of-the-money call or put option. As such, you are speculating that that individual has some rational reason for this level of commitment. On the other hand, the individual might be a mental patient. So I repeat what I said at the beginning of this article:
- While the potential upside is phenomenal, trading in stocks using surges in options volume is highly speculative and, therefore, very risky.
How We Identify Stocks That May Explode Using Options Volume
Now I’ll briefly describe what we look for in these options volume patterns.
First, we scan real-time through the entire option chains for all actively traded optionable stocks. We do this several times a day so that we can report to you an options volume aberration very soon after it occurs.
After getting the raw output, we throw out the thinly traded ones and look for sudden surges in call options volume in the rest by comparing today’s options with an average over a certain period of time.
Next, we filter out all the alerts that appear to be caused by
- arbitrage
- spread strategies
- institutional hedging
- important news that is already widely known
Finally, we analyze the technicals of the underlying stock and news that might have some relationship, but not necessarily a causal one, to the unusual options activity. We assemble all of the above into a big-picture analysis and hand it to you in TradersWire. From there, it’s your call. You should then evaluate the setup on the basis of your own technical rules, trading strategy, and risk tolerance.
Examples:
Spyglass
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On Oct. 22, 1999, several call options across different strike prices and expiration months in Spyglass had huge spikes in volume relative to the daily average. The high level of volume could not be accounted for through arbitrage, spreads, or other irrelevant factors, so that left us to guess that there were some people in there buying a boatload of calls for some reason.
As you can see in this chart, they were in the right place at the right time. In a purely speculative (and high-risk) play, you could have positioned yourself along with them and ridden a spectacular rise that began Nov. 1, 1999. The rise was accompanied by a news announcement that Japan’s largest Internet Service Provider had licensed Spyglass’ technology for delivery of information to wireless communication devices.
Praxair
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We noticed a high level of volume in the March and April calls across different strike prices in Praxair on March 7 and 8 which appeared to be the result of individuals going in and buying calls because they expected the price of the underlying stock to go up. What’s particularly interesting about this stock at the time of the call-volume spike, was that there was nothing at all attractive about this stock’s chart on the long side. On the basis of the stock’s strong downtrend from early January, you’d more likely want to short the stock or buy puts, than load up on calls. Obviously, you’d have to think that the call buyers are not in there to throw away money.
As it turns out, the move that ensued was not particularly earth-shattering on the chart. There was a one-day price surge on March 15, 2000, followed by some pullback action. But from an options trader’s point of view, that move on an out-of-the-money March call with a strike price of 50 would have at least doubled your money.
Phelps Dodge
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Phelps Dodge is a similar case to Praxair. On March 7 and 8, people were buying a lot of calls across different strike prices and expiration months in this technically poor-looking stock. The chart shows these people got a pop that would have generated a good profit on their call options.
Putting It All Together
Of course, we’d all like buy call options in a stock prior to a takeover announcement, every day of the week. But that, of course, is unrealistic. The best thing to do when you have information about unusual call-volume activity in a stock is to research and reason out the following:
- Look at the recent news. Do you see any kind of hint, rumors, about anything that might have a major effect on a companies earnings potential in the near future?
- Look at the chart. How does it look technically? Often, the most opportune setups are those in which you see sudden spurts in call volume in stocks that are trading quietly or in a downtrend. When you see no technical reason for buying this stock, you can make the educated guess that the people who are buying calls are doing so for some reason other than a nice-looking chart.
- Use common sense. I’ll say it for the third time in this article. This strategy is risky. Be careful.
Good luck. . .we’ll see you on TradersWire Interactive.