Scan The Market
If you go the route of identifying unusual options activity yourself, then you have to take a closer look at the scanner results. Also make sure to identify a potential IV Crush. An IV Crush often happens to short-dated weekly options near expiration date.
Start with this question: Do institutions buy a massive number of calls and put to generate high-percentage returns, or do they sell options trying to go for the premium? To answer this question, you only have to answer yourself the question of what type of trade has a lower risk and higher potential.
Buying calls and buying puts is equal to having a pre-defined maximum risk per trade and unlimited profit potential. Selling options, on the other hand, means that your risk is unlimited, and at the same time, the profit is limited.
This situation is similar to buying or selling stock by stock traders. Traders who buy stocks have limited risk if they buy them. But if the short a stock, then the risk is unlimited.
Trader A buys a stock for $1 per share. Trader B is shorting a stock for $1 per share. Both are 100% confident that the move of the share price will be in their favor. Trader 1 is looking for share prices to rise. Trader B is speculating on a further decrease in stock price.
After 14 days, the price is at $2 per share. At this point, Trader A made the same profit as trader B made losses. So at the moment, it looks equal. Now, another week later, the penny stock rose to $10 per share because an FDA approval gave the stock a boost, and now it is trading 10 times higher at $10.
At this point, Trader A made $9 per share and risked $1 per share as a max loss. But Trader B's maximum potential was to make $.99 per share in case that he can buy back the shorted stock at 1 cent per share. But now he faces a loss of $9 per share.
Another week later, the stock is at $100 per share. You get it right, Trader A made $99 profits per share so far by risking $1 per share, while Trader B lost $99 per share while he tried to make a maximum profit of 99 cents per share.
Another week later, it turns out that the company has to stop doing business, and the stock price falls overnight to $.01 per share. Both traders were holding the stocks all the time. Now they close the trade.
Who is the winner? Is it Trader B who closed out the trade for a profit of 99 cents per share? In between, he already had an unrealized loss potential of 99 dollars per share. Believe me; you will not be in such a situation trading stocks.
You will be Trader A, who had a pre-defined risk. Sure, in this example, it seems a bit crazy that Trader A did not sell the stocks for profits. But you get the point.
And what does it have to do with options trading? Well, that's simple, because it is even worse for those who sell options naked trying to get the premium.
Leverage and Profits
The leverage is much higher than by trading stocks, and one single naked option selling trade can cost you everything you have. I know, many advertisements promise something different. But just do the math by defining the maximum profit and maximum loss of investment.
Big institutions aim to utilize the huge leverage to generate 200%, 500%, or 1,000% returns buying options by risking just a fraction of the profit potential.
And what does that mean for investors who scan the market for unusual options activity?
Scanning for unusual options activity means that you need to identify big options trades that are:
- Speak for aggressive buying based on trade execution
- Unusual volume relative to the overall value of an underlying stock
- Options traded relatively high compared to the open interest.
If an options trade is executed at the ASK, then it speaks for aggressive buying because the trade was executed at the best possible price for immediate fills. If the price get's executed above the Ask, then it is even more aggressive buying of an options contract.
It is also a big difference, if 1,000 contracts for the SPY are traded at the ASK or if 1,000 contracts for a $10 stock are traded because the volume relative to the value of the stock is different. Just because you feel that 1,000 contracts are a lot, it does not mean that it is a lot. Therefore you need to look for what is relatively high options trading volume.
Another indication is the traded options contracts relative to the open interest. The open interest stands for the number of option contracts that have been traded but without an offsetting trade. If another trade with more options contract trades comes in, then you know that an unusual options activity takes place.
Putting all things together helps you to filter out the noise of irrelevant option activity. In the next step, you need to check if some specific event is coming soon. That can be:
- Earnings report
- FDA announcement
- Analyst meeting
If you spot unusual activity before such an event, then it might be that someone knows something or thinks to know something. Make sure to filter those trades by options volume too because you want to make sure that only huge institutional trades are being considered.
Therefore, go for a filter of options volume of at least 1,500 contracts per trade. This logic can be used for buying call options and buying put options.
As mentioned above, never consider selling options naked. If that could be done profitability with low risk, then institutions would do it, but they don't. Institutions buy call options and buy put options to benefit from the leverage.
Preperation and Trading
As an options trader, you need a scanner to find those trades, a news source to look for catalysts, your quote details to check the open interest, and finally, the options chain within your trading platform to place the trade.
Investors who are new to options trading should learn to trade options first. This can be done by joining the best options trading courses, and by making paper trades within the trading platforms. One single click can cost you money.
You need to be prepared to trade with real money. Education is one part, but practicing option trade placements is at least as important as education.
You need to understand:
- How the options chain works,
- The role of BID and ASK
- The meaning of a SPREAD
- Open positions
- How to close a trade
There are many more things to learn and practice before trading with real money. The stress level when trading with real money is much higher, and the higher the stress level, the more mistakes may be made. Become confident first and make sure that you understood the whole process.
When are you ready? You are ready to trade when you feel confident, and if you made profits with paper money for at least 2 to 4 weeks. The higher the data sample, the better. Statistical significance is essential to evaluate if you trained enough.
Unusual options activity trading is an excellent way to utilize the knowledge of hedge funds and other institutions. This type requires excellent analysis skills, a good trading platform, a reliable market scanner, and real-time news. Investors also need a reasonable amount of time to do the due diligence process to get into the trade on the same day.
An options picking service can be used as a short cut because the service does all the work for the investors. Using an options picking service still requires excellent trading platform skills and a good understanding of the option and stock market.
Joining such a service also requires a reasonable amount of data samples, and only if money trades are made with profits over a longer period, then real money trading should be considered.
It is important to integrate a good process during the trading day to spot and utilize this type of options activity. Hedge Funds on Wall Street have huge groups of traders, and they trade all day long because they take their job seriously.
You should treat your trading with the same respect as a professional, institutional trader. The more time you invest, the better your results will be. Start small, trade 1 contract once you made progress trading paper money. Trading 1 contract already means that you control 100 shares of the underlying stock.
Do it step by step and increase the leverage slowly. Make sure to reduce the contracts traded if things don't go the way you want or if the market is completely irrational or volatile. Unusual options activity will be here today, tomorrow, and for the next decade.