Trading on Unusual Option Activity

12/06/2012 3:45 pm EST


Andrew Keene

President and CEO, AlphaShark Trading

Learn how to read, analyze, and trade off unusual option activity and volume in any stock from Andrew Keene.

My guest today is Andrew Keene, and we’re talking about unusual option activity and how you use that to find good trading opportunities, so Andrew, how do you look at the option activity to find out where a good trade might be.

Yeah, basically, as a market maker on the floor for over 11 years and I use what I used on the floor, which is using unusual option activity, being able to read what paper is doing and paper’s just an order from a mutual fund, hedge fund, or a big bank when they come in and they buy calls or they buy puts, they buy straddles, trying to analyze what they’re doing.  Are they buying calls because they have a short stock position and they’re protecting it or they’re buying calls because they’re bullish on the stock, so I look at the unusual option activity.  Basically, every stock trades X amount of contracts in a day, something like XLF, maybe you’ll trade $100,000, maybe something like EAT, which is Brinker National, maybe trades 100.  When I see something that’s ten or 20 times usual volume, which means they’re trading at more than usual volume, I’ve started to have maybe put a trade on, then I go through the chart, I go through a risk rewards scenario where I want to put on a spread or maybe buy some calls.  I’m always defining my risk and reward, want to make sure the chart lines up, and then I have my time and my target of where I want to put a trade on for that option.

So let’s talk about that.  Just because you have unusual option, how do you know if they’re either just hedging a position or actually betting against something?  How can you tell?

Yeah, exactly.  That’s a great point.  I make that all the time.  Just because calls are bought isn’t always a bullish trade.  They could have a short stock position on against it.  Just because puts are bought doesn’t mean it’s always a bearish trade.  They could have a long stock against it, so what I do is I go through it and I always try to make trades which are opening positions, so when I look to the open interest versus the volume, when they’re the same, I don’t make the trade, so I want to do opening positions, then the second stop is the chart.  How does the chart line up, and I saw call buyers in Vale, XCO, a couple other stocks, and the chart was trending down, lower lows, lower highs, so I didn’t want to put on a bullish position.  I actually thought it was bearish, even though they were buying calls, so I combined that with the chart and then I structured a trade.  I want to take a risk reward scenario, maybe I’m selling a put spread, a condor, a butterfly.  I try to use all that in there and then I have a time period when the options going to expire.  I always want to know my breakeven, maybe a support, a resistance level, certain levels, moving averages, and I base the trade based on this unusual option activity.

All right, and so you talk about following a mutual fund or a large institutional investor.  How would you know that versus, say, just a large, individual retail trader?

Well, usually a large retail trader’s not going to trade a 5,000 lot and especially a $2 option.  That’s a lot of money and a lot of capital.  I always compare this to if I knew the hedge funds positions before they were announced from the SEC, if I could follow everything David Einhorn did, or if I could follow anything one of these big whales did before it was announced publicly, of course I would want to do this, so this order flow comes through.  We work with a proprietary software that shows every equity option trade across every exchange, and then I look, go through these, and I try to scan them to what I think is a good trade.  Like I said, I’m not in the business to be selling straddles naked, selling calls naked, selling puts naked, but I always try a risk reward scenario where I think the probability is in my favor.

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