What Option "Paper Flow" Can Tell You About Stock Prices

09/22/2010 12:01 am EST

Focus: OPTIONS

Mark Sebastian

Founder, OptionPit.com

During last Friday’s trading day, I took some time to break down the paper flow in Research in Motion (RIMM). There was an order that seemed to be getting traded over and over again. While there was heavy traffic across the board in RIMM, call volume far outweighed put volume, and bullish flow was far heavier than bearish flow. Even with that, there was one really strange trade that kept being traded: The September-October 50 call spread. Paper (a trader’s term for customer order flow) got long the time spread over and over again.   


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My best guess was the call spread traded over 30,000 times (it is hard to get an exact count). It is very strange for calls that are almost 10% out of the money to be the most heavily traded, and the fact that it was done as a time spread was telling. After I looked at the trade, I saw its merits to a trader that thought this was going to rally about 10%.  Up 10% with the VOL in the trade would return 100%. If RIMM ran up even 3%, the trade made money. In the event the trade fell, my best guess of the risk was about .60 a spread. If one wanted to get bullish, it was actually a pretty cheap trade.

Being one who follows paper, I threw on the trade for fun. Here is what it looked like at the close:


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I (along with those who really thought of this trade) looked brilliant around 4:45 when the stock was trading at 50. By my best guess, this would have been the payout in the morning:


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Even so, with the stock down to earth and trading around 48.00, this spread should return at least 25%. This is my best guess as to what it will look like if we stay here:


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Paper flow can be surprisingly telling. I tell all of my option mentoring students that if you think something is going to happen in a stock, and there are 50,000 contracts telling you differently, consider the fact that you may be incorrect in your analysis. I rarely, if ever, bet against heavy paper flow. Traders who did in this case are probably not very happy.

By Mark Sebastian of OptionPit.com

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