Did you know that back in the day, when trading was done on the floor, traders who discovered unusual options activities gave an open outcry like shouting and using specific hand signals?
When the option level of activity unexpectedly picked up, it meant that someone was loading up and likely knew something important—That’s when floor traders quickly jumped on the opportunity to piggyback on these orders.
Today, trading floors are mostly gone, so the way we identify big money coming into an option is just through volume and stock screeners. When an option that usually trades a few contracts a day suddenly trades thousands of contracts in only one day, we know a big move is coming.
That’s what unusual options activity is: It’s merely identifying specific options contracts that are trading a high amount of volume compared to the contract’s average daily volume.
High relative volume is sometimes meaningless; traders may bet wrong, and it could just be a hedge. But sometimes, unusual options activity can indicate a big move coming in the underlying stock.
Keep in mind that options have expiration dates – which means the buyers of huge option positions expect a move before the expiration date.
High relative volumes in a weekly option, means that someone is expecting a big move pretty soon.
Contrasting this to buying shares, it could be an institution establishing a long-term position without having expectations of any bullish price action in the short-term.
How to Identify Unusual Options Activity
The first requirement for unusual options activity is that the entire volume must be multiples of its average daily volume, usually at least five times the average daily volume. The higher it is, the more beneficial.
Any option trading a high relative volume is worth looking into, but we encourage you to pay close attention to the options that make large individual orders.
When this happens, it shows that one trader or institution is making a bet, hinting that somebody might have insider knowledge. These large individual orders could be the size of one day of average volume.
Example
Let’s say the average daily volume for an option is around 5,000 contracts. You should be looking for orders of 5,000 contracts or more. While this is a good indication, it’s not a requirement because some traders cover their size by executing orders in small blocks.
It is more complicated to track order flow like this in the stock market because of trading venue fragmentation and trade reporting rules.
However, all trades must go through a significant exchange in the options market at one point. This means there are no actual “dark pools” in the options market because we can see all trades right after being executed.
Next, we suggest looking for unusual options activity within short-dated out-of-the-money contracts. Significant volume in OTM options can indicate that a big move is on its way shortly.
Spotting Unusual Options Activity
Scanners or screeners search for unusual options activity. While most trading/charting platforms already have this capability built-in, they are usually unsophisticated scans. These free platforms can perform unusual options activity screens:
- Barchart
- ThinkOrSwim
These are paid scanners that have extra features to help you even further:
- Benzinga Pro
- FlowAlgo
- Black Box Stocks
There are multiple ways to scan for unusual options activity. The way you choose will depend on the available scanning criteria within your screener. Check out this criterion that can be used to scan for unusual options activity.
Remember that some scanners do all the work for you, while others require you to look at the volume in the options chain and cross-reference that with the time & sales.
- Volume/Open Interest
- Large inter-market sweep orders in one contract
- Short-dated options or high relative volume in OTM
Hedging Unusual Options Activity
Most of the stock market is owned by large organizations. These institutions usually build their position in stocks over several months hold their stock for the long-run.
Many times when institutions notice volatility on the rise. Whether by earnings reports or upcoming news, they choose to protect some of their downsides by purchasing options. When you see unusual options activity, it is frequently due to a large hedge taking place – not just someone expressing a directional view.
That’s because they usually want to hold onto their shares. They have a long-term outlook on the stock, and the short-term volatility won’t change their perspective.
Because these businesses are trading clients’ money, they don’t want the clients to get nervous, withdrawing their investments because of one small loss due to a big move in one stock.
It takes so long for an institution to build a position that they can’t just immediately sell without profoundly impacting the market. They will also face tax implications of selling the stock.
Considering these motives, it makes more sense for institutions to use options to reduce short-term exposure to stock than to sell shares.
Opening and Closing Orders
While there is a possibility of an unusual order simply being a hedge, the order could also be a closing order. Closing orders happen when an options trader is closing their position.
Typically, a closing order is easy to identify because an opening or closing marker is placed on orders by the exchange or the broker. But, it isn’t always the case.
The best way to interpret a closing order from an opening order is by observing the open interest, although this method still has its flaws.
For example, Hypothetical Capital Management believes that small-cap stock $XYZ could advance more than 30% before weekly options expiration. They organize a buy order in the OTM calls, and a market-making firm fills the order.
The market maker, now short several thousand OTM, calls in an illiquid name. Now they use other option strikes and underlying stock to hedge themselves. Both orders are opening orders; this raises the open interest.
From this example, we can assume that the unmarked order was an opening order.
On the other hand, the counterparty of Hypothetical Capital Management’s trade could be someone just using an order to close their large OTM call position. In this instance, the net effect on open interest is zero, making conclusions difficult.
Having a significantly higher volume than open interest means the large order could actually be an opening order.
Keep your eyes open.
Sometimes unusual options orders hit the tape but quickly announce an acquisition offer or a hedge fund taking a significant stock position.
These catalysts are unpredictable, and the large option order was the only accurate indicator that something was going on. Typically, however, things are a bit more transparent.
Which Side of the Trade
Generally, if a trade took place on the ASK or above the midpoint, it is usually initiated by the buyer. If a trade took place below the midpoint or on the BID, the trade is typically seller initiated.
Advancing the Catalyst
There are two types of catalysts: transparent unexpected catalysts. Unusual activity before a transparent catalyst (like an earnings report) means that a large order is likely betting on or hedging against the earnings report. The following are different types of transparent catalysts:
- Product launch
- Earnings report
- Dividend announcement
Plan for unexpected catalysts. These events aren’t disclosed in advance in filings or the press, and they come out of nowhere, leaving the market to act on demand. You’ll often see abnormal activity with no transparent catalyst in range, and then suddenly, an influential analyst upgrades the stock out of the blue. Check out these unexpected catalysts:
- Restating of accounting
- Short-seller releases a “short report.”
- An activist investor taking a position in the company
- Influential analyst upgrades or downgrades the stock
- CEO makes an unexpected comment
- Black swan event
- For example, finding a catastrophic safety issue in auto OEM’s vehicles or someone being poisoned by something in a packaged food company’s product.
Price Action
Always consult the chart to guestimate what is going on when information is absent. Richard Wyckoff teaches that the seeds of this catalyst (either transparent or unexpected) should be planted in the price action leading up to it because insiders are buying during the lead-up.
Usually, in the best setups, the UOA agrees with both the short and intermediate-term trends.
Putting it all together:
Being selective with your unusual options activity trades will serve as supplemental trades to your primary strategy.
High-quality UOA setups don’t happen all the time. But, high-quality trades that actually work can supply you with some of the most substantial internal rates of return (IRR) in the stock market.
This strategy is effective because of the low initial risk.
By purchasing options outright, your risk is curbed at the cash invested, and with the leverage you have in options, you don’t need to risk much capital to see big returns.
