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How To Profit From Unusual Options Activity

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by Gavin in Blog
January 28, 2021 0 comments

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Finding the right options to trade is an important part of being a successful options trader.

There are a variety of ways a trader can do this – from conducting their own research on fundamental conditions and/or technical indicators, through to consuming data and recommendations from outside sources.

Unfortunately, not everyone has the time, expertise or inclination to do the research themselves and third party recommendations can’t always be trusted due to bias or conflicts of interest.

Sometimes you’ve done the research but you want more data to confirm your view.

One of the best ways to satisfy all these needs is to look for unusual options activity.

This article will explore what is unusual options activity and how you can profit from this valuable data point.

What Is Unusual Options Activity? 

At its core, unusual options activity is exactly what the name suggests – unusual or abnormal activity occurring across one or more options.

For example, if the average volume of options for company ABC is 500, but all of a sudden it spikes to 10,000, it means an unusual options activity event has occurred.

A high volume event like this is significant because for large changes in volume to occur it means that either a lot of people are suddenly very interested in the option and/or some large investor is taking a major position.

Both of these situations can result in significant price movements and even changes in trend direction or magnitude.

I firmly believe insider trading still occurs and I pointed out a classic example in my post This Sh*t Is Rigged.

By identifying whether the unusual options activity is comprised of puts or calls, you can get an indication of the likely ongoing trend.

This is useful for either confirming your existing research or giving you an idea of what to trade next.

Of course, no move is ever guaranteed, so it’s not a fail-safe approach to profits.

Sometimes a particular move is already priced in or the market barely reacts to the change in volume, so knowing how to read these moves well and ensure you protect your downside risk is important.

How Do You Spot Unusual Options Activity? 

Up until the 2000s, most trading was done using the open outcry model.

This means that traders would gather in one place and literally shout out orders and send hand signals to offer and confirm trades.

Back in those days, it was not uncommon for floor traders to piggyback on an order by watching out for orders that were clear someone was loading up big.

Fast forward to today and the open outcry model has been replaced with sophisticated computer systems offering real-time insight into market depth.

As a retail trader, that means you can spot unusual activity simply by keeping an eye on volume.

You can also use a variety of screeners to automatically track and alert you to unusual activity in real-time.

There are several free screeners such as ThinkOrSwim and Barchart, and several paid screeners such as FlowAlgo and Benzinga Pro.

What you’ll specifically want to look for, are options contracts that are experiencing very high volume relative to its normal average daily volume.

Aim for a minimum of five times the average daily volume, but the higher the better.

Another useful filter is to only consider those options with large individual orders – this way you can screen out retail investors who may be reacting to a recent ‘hot tip’ in a media outlet and instead focus on a single trader or institution making a big bet.

Filtering for large individual orders isn’t a requirement as some traders will break their order up into smaller lots so they can build a bigger position over time without moving the price against themselves.

How Do You Profit From Unusual Options Activity? 

Options have expiration dates so it means that anyone taking a large position is expecting a significant move to be made before the expiration date.

Knowing this, you can exploit the position by making the same move (i.e. doing the same order).

The key risk in trading this strategy is that the unusual volume could be a sign of either:

  1. A big investor has entered a position as they believe a big move in the underlying stock is coming.
  2. A big investor has entered a position as a hedge.

In the case of (a), this is a favorable situation for individual traders if they place a similar position.

In situation (b), where the position is a hedge, individual traders stand to make a loss.

The reason being is that the large trader/institution is only protecting their portfolio and not acting on some strong conviction that the underlying stock will move strongly.

This means that the price is likely to revert quickly and possibly turn into a loss-making position.

That’s why it’s important to deploy risk-mitigation strategies like stop losses and appropriate portfolio sizing so that you don’t get caught out when the large position turns out to be a hedge.

You can also protect yourself by considering whether there is an upcoming catalyst.

For example, if there is unusual volume before an upcoming earnings report or product launch, it’s either a bet on that event or a hedge against it.

It pays then to dig a little deeper into the event and form your own position on whether it’s favorable for the underlying stock or not before doing a trade that follows unusual options activity.

Conclusion 

Unusual options activity is when an option experiences an unusually high volume of trades relative to the average daily volume.

By observing these events, it can give individual traders clues as to whether large traders and institutions are building up a position ahead of a significant move in the underlying stock.

Individual traders can profit from this information by executing a similar trade, however, it’s best to ensure you have adequate risk management processes in place in case the trade turns out to be a hedge.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

Download The 12,000 Word Guide

Get It Now