Another Footprint
The customary way to measure the degree of an option’s over- or under-pricing is the implied volatility, which changes over time, but normally not dramatically in a short period.
Suppose the implied volatility for an option series increases dramatically in one day from a level that does not differ by much from the historical volatility, without any commensurate movement in the stock. What does this mean?
Of course, it cannot happen that only a call implied volatility increases–the activity of converters ensures the premiums of both the call and the put with the same strike and expiration will increase in a similar way. So the implied volatilities of both the put and the call will have risen dramatically.
Quite possibly a large hedge fund purchased the straddle with this strike, causing both the call and put premiums and implied volatilities to balloon. But if the call volume greatly outweighs the put volume, it cannot have been a straddle purchase that caused the premiums to increase. Someone, or some group, made a large call purchase.
Of course, it is possible that a large fund merely purchased a large backspread, but this is not a plausible explanation if the implied volatility was not already very low. The most natural explanation is that someone knows something.
Suppose it was the put volume that outweighed the call volume. Then a competing explanation is that a large fund purchased puts to protects its large holdings in the underlying stock. Or, someone has some very interesting information about the stock and/or the company.
Insurance is almost always an explanation for unusual activity. In the case where the call volume greatly outweighs the put volume, it is certainly possible that a large fund wished to protects its short position in the stock and purchased calls for that purpose. But that is not likely. The trick is to weigh the plausibility of the various competing explanations.
There are about 30,000 option series on the market these days. The ability to follow the implied volatility of each individual series requires specialized software. But the principle is the same as with unusual volume activity: Unusual activity may reflect unusual knowledge, and warrants investigation.
We will be adding filters to ferret out opportunities suggested by unusual implied volatility activity and will post these candidates on the site soon.