How to Spot Unusual Options Trading

The options markets gave a great heads-up that a deal was brewing for First Data(FDC), and I noted that last Wednesday there had been a surge in call activity and suggested that options activity was speculative and that it indicated a buyout bid that would have a 25% price premium.

Jim Cramer picked up on that, too, providing further evidence that something was brewing when he noted on Friday that people were still buying calls hand over fist that day even as the stock fell in sympathy with competitor Global Payments(GPN) after that company reported disappointing earnings.

So while I like reveling in the light of being right, there is a question we should address: How does one identify what is simply unusual activity from something that is a tip that smart money is at work? Here are some basic criteria for separating the wheat from the chaff and, more importantly, identifying what options might deliver good returns and how to avoid chasing the activity that ends up being useless noise.

Volume and Volatility

First and foremost, look for an increase in call activity and an increase in open interest. More specifically, the volume should be at least three times the average daily volume, focused on near-term options and one or two strike prices.

Make sure the volume is not the result of a spread trade (the simultaneous purchase and sale of similar options but that have different strike prices or expiration dates). A spread is a much more neutral trade than the outright purchase of call options. Checking times and sales will reveal if these trades are outright purchases or part of a spread.

In the First Data case, not only was most of the activity outright sales, but there was also very little put volume. Four calls traded for every put, which also indicates it was bullish rather than hedging activity.

(You can check daily volume on the option chain provided at most brokerage firms' Web sites, or if you are willing to wait until the next morning, you can find free delayed data at the Options Clearing Corporation Web site.)