[From Options Profits at TheStreet.com] Calls and Puts serve a number of purposes for different types of traders and investors. A typical trading day in the US sees nearly 15million contracts change hands, with flow driven by a broad spectrum of participants; from hedgers to speculators, quantitative engineers to old-school chartists, well-informed insiders to ignorant newbies- all coming together to create a dynamic market where 3 to 4 Billion dollars in premiums change hands daily.
Identification and interpretation of ‘smart’ vs ‘dumb’ option order flow is a sub-specialty in modern finance and has become an important factor in the decision process for many investors, whether their approach is based on technical or fundamental analysis or micro- or macroeconomic views. Both types of option flow can be very useful to traders, with smart option flow having strong predictive value, and dumb flow presenting a simple opportunity to take a contrarian view. Academic research confirms the value of option information, but modern markets present serious challenges to even the most experienced, intelligent traders when it comes to smart, dumb, and neutral ‘paper’ – and that’s where we focus our efforts.
In our view, the most valuable trading opportunities come from matching the direction of smart order flow, whether to catch an insider-trading move, or simply to capitalize on good research. The primary factors we look at to identify this ‘smart’ paper include:
1. Call volume exceeding normal level
2. Traded Call/Put ratio above average
3. Increased level of implied volatility
4. Flattened put/call skew
5. Concentration of flow in out-of-the-money contracts
6. Call open interest growth
7. Concentration of flow in shorter-term options
8. Low incidence of complex order and ‘tied’ trade types
9. ISEE customer Index>100
10. Significant cumulative hedge delta
Most of these indicators can be flipped when looking for smart flow with a bearish bias, but our research has shown that the upside cases tend to be the more profitable trades. Given that 590,000 individual options are listed today, on more than 4000 underlyings, analysis of the 700,000 trades that take place each day is not easy, but good tools and some heavy computing power make it possible for market participants.
Let’s look at an example from earlier this summer (admittedly this is cherry picking a winner, – the challenge of isolating the true signal from the noise is also difficult). Shares of Leap Wireless (LEAP), a relatively low-cost cellular network and broadband provider, spent most of the spring in the $6 price range, with both implied and realized volatilities in the 40-60% zone- not unusual for a $6 stock in that sector (a 50% volatility suggest daily moves of about 3%).
During this interval, a few spikes in call volume are noted, but flow is generally steady in the 1300 contract per day range (and a call:put of near 2). Open interest is also steady, with nearly 25,000 calls open at most peaks (each dropoff in the chart is an expiration date).