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How To Use TM’s Indicators: Stocks With Abnormal Call/Put Volume

By Vincent Mao

TradingMarkets.com

In this lesson, we will show you how to use
TradingMarket’s

Stocks with Abnormal Call Volume and

Stocks with Abnormal Put Volume indicators to spot potentially big
movers. Each night, we scan through our universe of companies to find
stocks that show significant increases in options volume. Abnormal
options volume can often foreshadow events that can lead to big
movements in stocks.

The reason for this is
that traders who are able to establish large positions in calls or
puts, tend to be right more often than the general population of
traders. Why this is the case is open to speculation, but that is not
as important as the fact that being aware of surges in call or
put volume can give options traders an edge. However, be aware that
this is a very speculative and high-risk
trading strategy.

When a stock’s options
volume increases significantly, it is often like the calm before the
storm. Price action may seem quiet and not reflect any unusual
activity. But the huge spikes in underlying call- or- put volume can
be the signature for large informed players betting on important
corporate events and announcements that can have a significant impact
on the price of a stock.

Types of events that would
prompt such options speculation might include:

• Earnings reports that
  are substantially better than analysts’ estimates

• Earnings reports that
  are substantially worse than analysts’ estimates

• News involving new
  products and/ or services

• News involving new
  contract signings

• News involving FDA
  approvals

• News involving
  litigation and court rulings

• Takeovers

If the increase in option
volume is in calls, then the news or event will most likely be
positive and will propel the stock higher, whereas if the increase in
option volume was in puts, then the news will most likely be negative
and drop the stock lower. What we are trying to do is to identify and
figure out if that increased option volume is speculative in nature.

Therefore, we are not
concerned with increased option volume that is due to:

• Arbitrage strategies
  such as conversions and reversals

• Spread strategies

• Institutional covered
  call writing

• Institutional protective
  put buying

We will show you how to
screen out option volume due to these types of activities so that you
can find abnormal options volume that is of a speculative nature.

Screening out the Arbitrageurs

The

Stocks with Abnormal Call Volume and

Stocks with Abnormal Put Volume have some built- in arbitrage
filtering. You can refine the results further by looking at how much
of the options volume is concentrated in one or two series of options.

For example:

ABC Corporation = 50

Average daily option volume = 250 contracts

 

Calls	Volume	Puts	Volume
November 35	20	November 35	20
November 40	25	November 40	15
November 45	50	November 45	25
November 50	710	November 50	705
December 35	15	December 35	5
December 40	10	December 40	10
December 45	5	December 45	2
December 50	10	December 50	15
Total Calls	845	Total Puts	797
Total Option Volume = 1642 Contracts	Average Contract Volume = 250	Ratio = 6.57	Â

On the surface, it would seem that
something is up, since ABC Corporation’s options volume was over six
times its average. However, on further examination, we find that the
majority of the option volume was concentrated in one series, the
November 50 options. Although we don’t know for sure, we can suspect
that this increase in option volume is due to an arbitrage- type of
strategy, such as a conversion or reversal. While we cannot rule out
speculative activity, the chances of it being the root cause of the
high options volume is not high enough to present a viable trading
opportunity.

Screening out the
Spreaders

An increase in option volume can also
be due to large spread positions such as vertical spreads and ratio
spreads. If we suspect that the increase in option volume is due to
large spread positions put on by traders, then we can also rule out
the increase volume as speculative activity. Therefore, look for
increased activity that is concentrated on two series of options. The
volume on those two series should be similar.

For example:

XYZ Corporation = 70

Average daily option volume = 500 contracts

Average call volume = 295 contracts

Calls	Volume	Puts	Volume
November 60	45	November 60	25
November 65	75	November 65	37
November 70	525	November 70	80
November 75	70	November 75	35
November 80	500	November 80	27
November 85	22	November 85	17
November 90	7	November 90	1
December 60	50	December 60	5
December 65	25	December 65	2
December 70	15	December 70	5
December 75	35	December 75	18
December 80	5	December 80	0
December 85	2	December 85	0
December 90	0	December 90	0
Total Call Volume	1376	Ratio to Average Call Volume	4.66

XYZ’s call option volume
was over four times its average today. You can suspect that something
is up. However, on further examination we find that the majority of
the volume was concentrated in the November 70 and November 80 calls.
This could be due to large vertical spread position and not
speculative activity.

Screening out covered call writing or protective put buying

Sometimes, increased
option volume is merely due to institutions writing covered calls or
institutions buying puts to protect their portfolios from a decline in
the overall market. If this is the case, then we can rule out any
signs of speculative activity.

For example:

ZZZ Corporation = 41.75

Average Option Volume = 400 contracts

Average Call Volume = 225 contracts

Average Put Volume = 175 contracts

 

Calls	Volume	Puts	Volume
November 30	25	November 30	2
November 35	35	November 35	22
November 40	75	November 40	50
November 45	100	November 45	55
November 50	70	November 50	15
November 55	20	November 55	3
November 60	5	November 60	2
December 30	3	December 30	0
December 35	17	December 35	22
December 40	48	December 40	5
December 45	1000	December 45	18
December 50	5	December 50	0
Total Call Volume	955	Ratio to Average Call Volume	4.24

ZZZ Corporation’s call
volume was over four times its average today. However, we see that the
majority of the call volume was in the December 45 calls. Therefore
suspect that someone, perhaps an institution is writing a large number
of calls, thus this increase in volume is not due to any speculative
activity.

Other Considerations

Usually, increased option volume will
show up in the front month at-the-money or out-of-the money options.
This is because these options will give them the most leverage.
Therefore, deep in-the-money option will most likely not be used. In
addition, if the front month options have only a week or two until
expiration, you may want to look at the next expiring months.
Keep in mind that this method
is still subjective, since there is no real way to know who bought and
sold all of these options. However, we have shown you some tracks that
have been left behind which could suggest that a big move is in
store. 

Examine time and sales information for signs of institutional
activity. For example, a trade of several hundred to several thousands
of contracts is usually an indication that institutions are at work.

Kmart Corporation (KM)

On Aug. 24, 2001, Kmart Corporation
showed up in our

Stocks with Abnormal Put Volume indicator. Put volume on Kmart was
over 20 times its average.
Upon examination, we did not find any red flags that suggested that
the increase in volume was due to activities such as arbitrage,
spreads, institutional covered call writing or put buying. The
majority of the volume was concentrated in the front month Sept. 10
puts and the Dec. 10 puts. One week later on Sept. 6, the company
reported disappointing August same-store sales, which drove the stock
down over 38% in a week!