Today’s Trading Lesson From TradingMarkets

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.

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:

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.

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 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.

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.