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The Ugly Side Of Trading Unusual Options Activity

I've said this before, I'll say it again, there are literally hundreds of thousands of option orders that are reported every trading day. The majority of the option volume conducted is done by large institutions-who have the potential to move a stock with their order flow.

Not only that, institutional option flow is highly regarded as informed traders, a great deal of interest is grown when an aggressive bet is made, followed by speculation on why they put so much money behind their idea.

Now, If you can imagine millions of orders being tracked every day, you can see how there could be a lot of noise in between… even though I believe following the transparency of option market trades provides excellent signals for potential entries.

However, with that said, making investment decisions simply based off large order flow or unusual options volume is not enough. You've got to put the order flow into context…spotting unusual options activity is just the first step.

A large option order could be done for a number of different reasons, sometimes they can even look deceptive. For the most part, options can be used to hedge an existing position or for speculation. The SIZZLE Method attempts to dissect unusual option activity in order to generate trade ideas and structure trades.

Throughout the weekday, I'll post some of the interesting orders on our Twitter page. These posts are not meant to be investment advice or recommendations…just observations or ideas on how to better structure a trade for greater chance of making a profit.

Here's an example of activity I posted for those that follow me on Twitter. On August 13, 2014, I posted a tweet when I noticed very large buyers of calls coming in the September 90 strike.

With the calls being bought in massive volume, it seemed they were making a directional bet that shares of Marathon Petroleum Corporation (NYSE:MPC) might be above $90 a share at expiration on September 19th.

However, I've noticed that some option investors do take them as such. I even wrote an article about this: Why You Keep Losing Money Following Trade Ideas.

Whether it's me posting or someone else who you respect…you've got to roll up your sleeves and do some more work before committing hard earned money to a trade.

I've been on Twitter since 2008, On thing I have noticed is there a lot of people that just like to post things that have no skin in the game. That is why I focus on empowering YOU to be dependent on your analysis. I emphasize this more in, "What's Your One Best Trade Idea Right Now?"

In the SIZZLE Method, I stress that once you find an unusual options trade, you've got to hone in with your inner detective. The idea is to try to get into the smart money's shoes and figure out what they're implying by their trades.

It starts with a series of questions.

  • Is this a stock replacement ahead of earnings?
  • Is there M&A chatter surrounding the stock?
  • Could there be a government (domestic or foreign) law or ruling coming out that could affect the stock?
  • Is there chatter that an activist investor might be involved in the stock?
  • Does the stock have an investors conference or analyst day coming up?
  • Have you seen unusual options activity in the whole sector or just this stock (sector rotation)?
  • If it's a drug company, do they have an FDA announcement pending?
  • Recently, has there been negative or positive news said about the stock from a research firm, hedge fund or other influential establishment?
  • Is this order a potential hedge against a stock position?
  • Does this stock correlate with the S&P 500?

Now, I could keep going…but I think you get the picture. After trying to figure out the why (sometimes you will never figure out it, those are usually the unethical trades), I'll then look at liquidity.

Unless I can figure out what the catalyst is, I'll look to trade options on stocks that have competitive bid/ask spreads. If you're not sure what that is, check out: What Are The Best Stocks To Trade Weekly Options?

After that, I'll check out my thinkorswim platform and look at the option volatility levels, are premiums relatively rich or cheap?

For example, if I see a large block of calls sold near the stock price is near 52 week implied volatility highs when volume is higher than open interest…I'm not automatically thinking that it's a bearish trade…but it could be a covered call or some type of volatility play.

Heres another one, a large trader buys calls when the stock is selling off when open interest is higher than the volume…in this case, I would have to look back at previous order flow to see if they are closing out a short call position vs. assuming it's just a bullish play.

Even after all that work…

I still have to compare this opportunity with the others I've seen that day. I'm not sure about you, but I don't have unlimited amounts of capital in my trading account. If I allocate money in one trade that leaves me with less cash for another opportunity.

Not only that, if it's a directional trade, I've got to ask myself if I want to be long or short a stock given the current market conditions. This means checking out where the S&P 500 and CBOE Volatility Index (VIX) stand.

For example, if you've got a long bias, how are your options going to perform if there are geopolitical tensions overseas and the S&P 500 sells off? Or if the market rips higher, will your long bias options follow?

Furthermore, if I establish a market neutral, short premium position, I've got to make sure that my delta's are fairly balanced so I don't have too much directional exposure.

In addition, it's important identify the type of position that the smart money established. For example, are they playing for a near term event…in this case, we'd see weekly options heavily traded. Furthermore, if we see long-dated options traded, I might assume that it's a position trade or investment.

If you're in a long term trade….

How do you feel about having your capital tied up for a while? On 6/30, Dollar General (NYSE:DG) saw massive call buying in the November 62.5 call strike…over 61k contracts for $2.35…well, you would have had to of waited till 8/18 to get finally get paid on those calls when they traded over $4 per contract.

Bottom line, there's got to be some thought put into your trades besides copying a large unusual options trade. I know this…but I forget sometimes that not everyone does.

I posted that on 8/18, when Solar City was trading around $72.50 a share. Now, SCTY trades around 30k contracts a day…and on 8/18 it traded around 18.5k contracts. With that said, there wasn't unusual options activity in SCTY…however, I felt that it was a pretty odd order given how far OTM it was and the amount of time left on the contract…so I posted it on our Twitter stream.

Why was this interesting?

Well, this is a pretty volatile stock in a volatile sector…it has the potential to run for no rhyme or reason. Second, the order was a type of order called an option sweep, which is pretty aggressive. In any event, I would categorize it as a lottery ticket…a very low probability trade.

This not the type of trade I would do if I had a small account. Sure, $30 a contract is cheap…but they're cheap for a reason…and if you're trying to build a small account up…these are the types of trades you should avoid.

Think about it in poker terms. If you're the small stack at the table, your best bet is to only play when you're dealt a premium hand. The big stack at the table can afford to play all types of hands because they can afford to gamble a little.

It's sort of the same idea in option trading…if you're the small stack, always try to put on trades that have a high probability of success.

I actually received an email from a follower who mentioned they took the SCTY trade I tweeted about. I probably should have added in that tweet that the order was a lottery ticket. I really felt like a jackass after receiving that email.

You see, that wasn't a trade I would have chased… but how could anyone know that from reading that tweet?

Easy, they couldn't have…and because of that I feel that i need to take ownership of it.

I know there are a lot of people out there posting 10-15 tweets a day about unusual options activity orders. When one of them hits, they are the first to let you know that they spotted the big winner. In my case, I would rather focus on quality vs. quantity…sometimes my analysis is wrong and I end up losing money on my ideas.

However, I know if I play the numbers game with my strategy, I'll end up being net profitable.

Twitter, Facebook, Google Plus and email are all ways that I communicate with my clients & followers and I am grateful for these platforms. However, my posts on social media should not be taken as trade recommendations.

With that said, I understand that there option investors out there who are interested in my ideas and would like to learn more about my trading style ( that goes beyond 140 characters). That's why in the coming weeks I'll be launching a service that focuses on actionable ideas along with how to structure trades to potentially profit off them using my SIZZLE Method.

It's going to be awesome for those who not only want option trades but also want to interact, learn and ask questions about options investing. I promise to have more details out to you as soon as I get them.

Now, if you're looking for a primer and are looking for excellent signals for potential entries, check out the SIZZLE METHOD REPORT. I'm going to be offering those that purchased the report beta access first when we launch the service.

By the way, have you ever made a trade based off unusual options activity that you got from a social media post and lost money? If so, I'd love to hear your thoughts, I'll be hanging out in the comments section below.