As “options guys” we get a lot of questions about unusual, large or just generally interesting options activity. I rarely make trading decisions based on said activity, but I don’t feel uncomfortable explaining and commenting on it as that color is often what’s missing in other “follow the flow” services. As I have stated many times on CNBC, on this site, and very specifically in the post below from February 11th (unusual Options Activity: Why it Can Matter & Why it Usually Doesn’t) trading based on unusual activity is more complicated than you think and very susceptible to confirmation bias:
blindly following the “big” money simply because of large options trades can be a dangerous game in situations where the activity could be hedging against the traders larger position in the underlying. Options activity is worthwhile to follow as one piece of the trading puzzle, but only as one piece. Traders should be careful about those touting strategies that follow the big prints as a method in itself. The issue is compounded by a confirmation bias on the part of those touting large options activity as the only input in a new trade.
Which brings me to a situation from yesterday in a trade that I was intimately involved in and that I saw reported on a professional service that I subscribe to and think very highly of. The situation highlights the point I make time and time again. Unless you have certain knowledge of the initiating trader’s inclination (opening, closing, delta neutral, against a long or short position, among other inputs) trading based on the print itself is flying blind.
So first I’ll explain the trade. Then we can go over the mistaken coverage of it.
Yesterday, I was speaking to a friend who trades a large volatility book at a large institution. We were discussing ORCL’s upcoming earnings announcement on Dec 17th and concluded that the implied move for the event seemed fair or reasonable (not expensive, not cheap), but perhaps owning the move between now and Dec 17th could turn out to be really cheap.
He decided that he wanted to buy the Dec 42 straddle (long the dec 42 call and the dec 42 put when the stock was $41.94) and was willing to pay $1.80 for it.
If you owned that straddle for $1.80 you would need a move above $43.80 or below $40.20 on Dec expiration to make money, but if you are a vol trader your intent would be to scalp the stock between now and the earnings event. As the stock moves up and away from the long strike, you gain long deltas and can sell stock against them. As the stock moves down and below the strike, you gain short deltas and can buy stock against them. Do that over and over between now and expiration and you can make more money buying low and selling high than your position loses in decay. That’s the goal at least.
Well, the trader was not able to find a suitable offer on the straddle as market makers did not want to sell the earnings move, so he decided to buy the Dec 42 puts that were offered and buy stock against the puts so that his position was delta neutral (replicating the straddle by owning puts and synthetic calls (long stock + long puts)). This left him with a synthetic straddle and a long vol/ long gamma position, not a directional one.
So the guys at Trade Alert (who I think do great work) see 7185 puts swept, outright and simply assume that this was a bearish directional trade. They have no way of knowing what the trader’s intent was or if he may be hedging the puts. So it is reported this way:
optionalert [03:16:30 PM]:
Market Color ORCL – Bearish flow noted in Oracle (42.00 -0.18) with 16,865 puts trading, or 3x expected. Most active are Dec $42 Puts and Dec $42.5 Calls and the largest trade was a 7,185 lot of Dec $42 Puts. (Trade Alert LLC)) [$42.00 -0.18 Ref]
If you were trying to follow the money that certainly looks like a big player making a decisive bearish bet. But the problem is not only do you have the wrong information to work on but you’re now paying up in vol terms when you chase that trade. The sweeping nature of the transaction caused market makers to raise their offers on short dated ORCL options. And this is compounded remember, because market makers had already been reluctant to sell Dec options and that’s why my friend was forced to change his trade.
So the lesson here is the same one I’ve harped on before. Options flow is useful and we highlight alot of it with what we think is unique color. And slightly more than 50% of the time it’s probably clear what the intentions of the initiating traders are. But beware of services pushing this idea that all you need to do is follow the options flow they report to “trade like a pro.” That’s not how this works.
Original Post from Feb 1tth, 2014:
Unusual Options Activity: Why it Can Matter & Why it Usually Doesn’t
The financial media likens unusual options activity to some sort of tell as to what the “Smart Money” is doing. In some ways, that is correct but in other ways it can be very misleading.
Most savvy traders will take the time to try to get a sense for the options flow in a stock they are involved in, to glean speculative sentiment in the stock. Gauging sentiment is probably the main reason we highlight unusual activity, or changes in open interest. Particularly in situations where a stock is in an extended position (either high or low), options activity can sometimes signal smart money starting to get contrarian (one large block going the other way), or dumb money getting euphoric (lots of small lot activity going the same way).
However, we have always been skeptical of reading too much into unusual options activity. There have been many times in our collective careers where we have traded or seen others trade calls or puts as an offsetting position against the actual directional trade. For example, one hedge fund manager back in the summer of 2008 would notoriously sell puts on some of the distressed financial stocks (like Washington Mutual), but would be shorting stock against those put sales one for one. He was taking advantage of the high implied volatility on the downside to collect some extra premium, but his put selling activity was actually the opposite of his actual directional position.
Alternatively, we’ve seen many situations where large traders have bought puts or sold calls against a new long position. One of my favorites was a trader who would buy up his stock position first, and then ask for an offer on puts in that stock. Since he was the one who drove up the stock in the first place, he got a better entry on the stock and long put combo than if he had traded both together.
The point here is that blindly following the “big” money simply because of large options trades can be a dangerous game in situations where the activity could be hedging against the traders larger position in the underlying. Options activity is worthwhile to follow as one piece of the trading puzzle, but only as one piece. Traders should be careful about those touting strategies that follow the big prints as a method in itself. The issue is compounded by a confirmation bias on the part of those touting large options activity as the only input in a new trade. You’re likely to hear about the ones that worked, and not a peep about the ones that didn’t.
So be careful on this strategy. Don’t blindly follow unusual activity in options without looking at other inputs. Because oftentimes, you won’t be following the smart money, but rather walking blindly into a stampede with the rest of the herd.