Warrior Trading Blog

How to Trade Unusual Options Activity

Unusual Options Activity

Back in the days when most trading was done on the floor, traders identified an unusual options activity (or any security for that matter) was through open outcry: shouting and hand signals.

When the level of activity within an option dramatically picked up, that was a sign that someone was loading up, and probably knew something. It wasn’t unusual for floor traders to piggyback on these orders. 

Nowadays, with trading floors mostly gone, the way we identify big money coming into an option is simply through volume and stock screeners. If an option that usually trades a few contracts a day suddenly trades 5,000 contracts in a day, someone is betting that a big move is coming.  

Unusual options activity is simply identifying specific options contracts that are trading a high amount of volume relative to the contract’s average daily volume.

This high relative volume is sometimes innocuous; it could be a hedge, and the traders do get these bets wrong, but sometimes, unusual options activity indicates that a big move in the underlying stock is coming. 

We have to remember that options have expirations date. This means that the buyers of these huge options positions expect a move to be made before the expiration date.

If we see a high relative volume in a weekly option, we know somebody is expecting a big move very soon.

If we contrast this to the outright buying of shares, that could be an institution establishing a long-term position, without any expectation of bullish price action in the short-term. 

Identifying Unusual Options Activity

The first prerequisite for unusual options activity is that the total volume must be multiples of its average daily volume, typically at least five times the average daily volume. The higher, the better. 

While any option that is trading a high relative volume is worth taking a look at, we want to pay extra attention to the options that make large individual orders.

This indicates that one trader or institution is making a bet, suggesting that someone might have some insider knowledge. I consider a “large individual order” to be about the size of one day of average volume.

Example

So if the average daily volume for the option is about 5,000 contracts, we’re looking for orders of 5,000 contracts or more. Although this is a good sign, it’s not a requirement because some traders will hide their size by executing orders in small blocks. 

In the stock market, tracking order flow like this is more complicated, due to the fragmentation of trading venues and trade reporting rules.

However, in the options market, all trades must go through a major exchange at one point, meaning there are no true “dark pools” in the options market because we see all trades print on the tape relatively shortly after they’re executed. 

Next, it’s definitely preferable to look for unusual options activity within short-dated out-of-the-money contracts. Significant volume in OTM options is suggesting that a big move is expected within a short period.

How To Find Unusual Options Activity

There’s a litany of scanners/screeners that scan for unusual options activity, and most trading/charting platforms have this capability built-in. This is a technologically unsophisticated scan, and the following free platforms can perform unusual options activity screens:

Here are some paid scanners that have some extra features that might be desirable to you:

There are a few ways to scan for unusual options activity, and your way will ultimately depend on the scanning criteria available within your screener. Here’s a list of criteria that can be successfully be used to scan for unusual options activity.

Keep in mind that some scanners will do all the work for you, while others will require you to look at the volume within the options chain and cross-reference that with the time & sales. 

  • Volume/Open Interest
  • High relative volume in OTM or short-dated options
  • Large inter-market sweep orders in one contract

Unusual Options Activity Is Often Hedging

Remember that most of the stock market nowadays is owned by large institutions. These institutions typically build their positions in stocks over several months and plan to hold the stock for the long-term.  

Many times when institutions sense volatility on the precipice, whether that’s in the form of an earnings report or upcoming news, they opt to protect some of their downsides by buying options.  

It’s essential to keep in mind that, frequently, unusual options activity is due to a large hedge taking place, rather than someone expressing a directional view.

 The reason for this is that they generally want to hold onto their shares. They have a long-term view on the stock, and the short-term volatility won’t change their perspective.

However, because they’re trading client money, they don’t want their clients to get scared and withdraw their investments because one quarter they show a small loss due to a big move in one stock.

Also, because it takes so long to build for an institution to build a position, they can’t quickly sell without heavily impacting the market. There’s also the tax implications of selling the stock to consider. 

Because of the motivations mentioned above, it generally makes much more sense for institutions to use options to reduce their short-term exposure to a stock then actually to sell shares. 

Opening vs Closing Orders

In addition to the possibility of an unusual order simply being a hedge, the order could also be a closing order. A closing order is what it sounds like: when an options trader is closing their position.  

Most of the time, a closing order is somewhat easy to sniff out because there is usually an opening or closing marker placed on orders by the exchange or broker. However, this isn’t always the case.

In these situations, the way to decipher a closing order from an opening order is by observing the open interest, but even this method isn’t infallible. 

For instance, Hypothetical Capital Management has the conviction that small-cap stock $XYZ will advance more than 30% before weekly options expiration. They institute a buy order in the OTM calls, and the order is filled by a market-making firm.

The market maker is now short several thousand OTM calls in an illiquid name, so they use other option strikes and the underlying stock to hedge themselves. Both orders were opening orders, which raises the open interest.

This is one of the situations where we can infer that the unmarked order was an opening order. 

In other cases, the counterparty of Hypothetical Capital Management’s trade might be someone who is using their order to close their own large OTM call position. In this case, the net effect on open interest is zero, making it difficult to make inferences. 

When volume is significantly higher than open interest, the chances are that the large order was an opening order. 

Things To Look Out For

Sometimes we’ll see an unusual options order hit the tape, only to hear an announcement of an acquisition offer or a hedge fund taking a significant position in the stock.

These types of catalysts are unpredictable, and the large options order was basically the only indicator that something was happening. Other times, though, things are a bit more transparent and suspicious. 

Often we’ll see large UOA before options expiration,

Which Side of the Trade

As a rule of thumb, if the trade took place on the ASK, or above the midpoint, the trade is typically buyer initiated. If the trade took place below the midpoint or on the BID, the trade generally is seller initiated.

Ahead of Catalyst

There are two types of catalysts: transparent catalysts and unexpected catalysts. When we see unusual activity ahead of a transparent catalyst, like an earnings report, we know that the big order is probably either betting on or hedging against the earnings report. Here are a few types of transparent catalysts:

  • Earnings report
  • Dividend announcement
  • Product launch 

Then, there are unexpected catalysts. These are events that weren’t disclosed beforehand in filings or the press, they come out of nowhere and the market has to react on the fly. Many times, you’ll see unusual activity with no transparent catalyst in sight, only for an influential analyst to upgrade the stock out of nowhere. Here are a few types of unexpected catalysts:

  • An activist investor taking a position in the company
  • Short-seller releases a “short report.”
  • Influential analyst upgrades or downgrades the stock
  • CEO makes an unexpected comment
  • Restating of accounting
  • Black swan event
    • An example of poison being found in a packaged food company’s product, or finding a catastrophic safety issue an auto OEM’s vehicles.

Price Action

When information is absent, we should consult the chart to guestimate what is going on. If we listen to the teachings of Richard Wyckoff, the seeds of this catalyst (transparent or unexpected) should be planted in the price action leading up to it due to insiders buying during the lead-up. 

Mostly, in the best setups, the UOA agrees with the short and intermediate-term trends.

Bottom Line

If you’re selective with your unusual options activity trades, they’ll typically serve as supplemental trades to your primary strategy.

High-quality UOA setups don’t occur every day. However, the high-quality trades that do work give some of the strongest internal rates of return (IRR) offered in the stock market. 

The best thing about this strategy is the low initial risk.

Because you’re buying options outright, your risk is capped to the cash invested, and because of the leverage inherent in options, you don’t need to risk much capital to see generous returns.

0 Comments

Leave a Reply

Your email address will not be published. Required fields are marked *