A Reliable Option Volume “Tell”

02/14/2012 8:30 am EST

Focus: OPTIONS

Joe Kinahan

Chief Market Strategist, TD Ameritrade

Be careful using option volume as an indicator, warns Joe Kinahan, but a recent earnings season example shows that volume can give clues as to where others are placing buy and sell orders.

By watching option volume, you can get an idea of what’s going on in the options market and outside of it as well. Our guest today is Joe Kinahan to talk about how you can monitor that and maybe get an idea of what traders are thinking.

So, J.J., can I look at options volume and get an idea of what other option traders are doing?

I hate to answer a question “Yes and no,” but I’m going to in this case. So I’ll tell you the “no” first, and then tell you why sometimes you can. 

The reason you have to be careful when you do this is because options are a derivative product, so they’re getting their value from something else. Often, if someone buys calls, they may be selling stock against it, so you have to be a little bit careful there.

But I do think there are some times that are, shall we say, “tells.” We’re doing this interview in Vegas, so I think we should use a little bit of gambling-type terminology.

We saw a very good example of this recently: we just finished earnings in Home Depot (HD), and in that particular stock, the day before earnings comes out in the a.m., we saw big buyers of the just-out-of-the-money, front-month calls. I believe that there was an open interest of about 2800; and 10,000 traded there. 

When you see a just-out-of-the-money call or just-out-of-the-money put, that’s where the speculators tend to be, and particularly when the volume is bigger than the open interest, that means people are opening positions there. 

So when you start to see things like that, I think that earnings is usually the greatest time just to tell what people are doing one way or the other, and you can often see this pattern.

Those folks were successful. The stock opened up the next day, and they did have a chance to sell things higher. Again, that’s not always going to be the case, but that’s the time when I think you get the best idea of what others are doing.

Just because someone buys puts doesn’t necessarily mean they want it to go down, though. They could own a lot of stock on the other side. So I would caution people not to say that they “definitely” know what the person has in mind.

So it sounds like the options market is a great place to kind of judge sentiment on individual shares.

Yes, and I would say that with sentiment, the more you are around earnings, the easier it is to tell what the sentiment is.

When you’re just kind of in the middle of a trading cycle, sometimes that can be a little more difficult, but I think earnings season is the time where people care more about that also.

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