Sometimes, Wall Street has a very convoluted way of looking at things. For instance, consider the term “smart money.” One would think the term “smart money” would refer to a professional investor with incredible talent or a fund manager, market strategist or analyst that has had consistent success over different market scenarios, spanning many years.
What do we mean by this?
When a stock’s option volume and implied volatility increase significantly, it is often a harbinger of things to come. Although the stock’s price action may seem quiet and uneventful, not reflecting any unusual activity, the stock’s option activity can be telling a very different story.
An unusual and greater than normal increase in option volume or implied volatility can be an indication that large, informed ‘smart money’ players (the elephants) are placing bets on upcoming events or announcements. These announcements can often have a significant impact on the price of the underlying stock, as with important corporate earnings, or other news.
These “smart money” traders or “insiders” who have privileged information will try to act on this information before it becomes public knowledge. The trading of options allows these “well informed investors” to increase their leverage and enables them to maximize their gains without risking their identity.
So how can we, as retail investors, benefit from this knowledge?
A significant increase or abnormal fluctuation in the trading volume of a stock’s options and/or a substantial increase in the daily implied volatility of the stock’s options can be a precursor of a major movement of the respective underlying stock.
Sudden changes in options volume and implied volatility can be a tip off to potentially explosive moves in individual stocks. A move of great magnitude is almost always going to be fueled by news, but correct analysis of option order flow can alert one before the news is disseminated to the public.
Often this type of news strikes hard at the heart of a company’s future prospects for growth and profitability.
Examples of these types of news are the following:
1 Earnings substantially better or worse than Wall Street expectations
2 New product developments or breakthroughs
3 Mergers and acquisitions
4 Upgrades/Downgrades coverage by Wall Street Analysts
5 Media coverage
6 Products waiting for FDA approval or in clinical trials
And fairly often, this type of news is leaked. The people and organizations who know about this information will use it to their advantage. By looking for this unusual option order flow, traders can spot unique opportunities and bank big profits just by ‘following in the footsteps of elephants.’
There is more to this strategy than we will get into here, like making sure that there is not also abnormal options size on the opposite call / put options (usually just indicates hedging), but it still can be a very effective ‘clue’ to be aware of.
Since wagers are based on irregular movements in respective companies, this strategy’s performance is not dependent on interest rate stability, favorable stock market environment or any other market factor. This may present major profit opportunities, and returns can sometimes be far superior when compared to other strategies.
Conclusion: this trading strategy analyzes options data for the purpose of identifying significant increases (or abnormal fluctuations) in trading volume and volatility of the stock’s options as an indicator of movement and the timeliness of that movement in the underlying security. Options order flow analysis can be an indicator of “smart money” positioning, prior to publication of significant business announcements.
Another clue traders can look for are ‘block trades’ on the TOS (Time of Sales) reports. This is a related strategy, and does not necessarily indicate ‘insider’ buying, but can alert the astute trader to large institutional blocks of options being bought on either side of the underlying stock.
For example, if the average option trade size on a particular stock’s options is 5, 10, or 20 contracts, and you suddenly see large blocks of 200, 500 or 1000 contracts going into the close, then this is sometimes noteworthy and worth paying attention to the underlying stock.
For more Information about option trading, please click here: Options University
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