Options 'Flow' Foretold Questcor Plunge

Let's discuss interpreting these unusual trades. Unless you see the trades go through or have access to the size and pricing data (most retail traders don't), making sense of unusual option flow is more of an art than a science. I suggest you observe what is known and draw the most probable conclusions.

First, find what trades appear linked. With respect to small-cap biotech stocks, this is usually very obvious. For example, the figure below shows the option chain for typical small-cap biotech stock XYZ. The Bid/Ask spreads are wide, option volume and open interest is sporadic and unevenly dispersed. Note the unusual trades in the SEP 5.0 Puts and SEP 7.0 Calls where 3,000 volume just passed (unusual due to size relative to both volume and Open Interest or O.I.)

The first assumption is that these trades are linked. It's possible that two separate traders in two different locations put on these trades in exactly the same size and on the same date, but that's obviously unlikely. Next, look at how these trades were executed i.e. were they sold or were they purchased? (As each respective trade is larger than current O.I., we can assume they are opening positions.) In this situation, we know the "last" price of both trades. For the Calls, 3,000 were transacted at 95 cents and for the Puts, 3,000 were transacted at 80 cents.

Next, compare the prices transacted to the current bid/ask prices to get an indication of whether or not they were bought or sold to open. The Calls appear to be initiated on the buy side as 95 cents is closest to the ask of $1. The Puts, on the other hand, appear to have been initiated on the sell side, as 80 cents is the current bid quote.

An alternative approach would be to observe changes in implied volatility (IV) from the trades: Where an increase in IV would be indicative of buying activity and a decrease in IV would be indicative of selling activity.

The last step is to determine if the trade is bullish or bearish. Based on our analysis, the XYZ option trade appears to be a SEP 5.0 Put, SEP 7.0 Call Risk Reversal done for a 0.15 Debit 3,000x. This is a bullish trade.

Following unusual option activity helps manage risk in existing position and can also identify potential new trades. Monitoring flow is not foolproof but following "big money" trades can give retail traders a solid edge.

Disclosure: No positions in QCOR.

To learn more about using options to trade biotech stocks, check out Tony Pelz's book, The Biotech Trader Handbook or subscribe to Chimera Research Group

Tony Pelz was a trader on a major European bank's proprietary trading desk, responsible for a portfolio with limits of more than $200 million. Prior to proprietary trading, Pelz worked with several global investment banks in roles ranging from corporate finance, M&A to credit and business development. He is author of The Biotech Trader Handbook, 2nd Edition, co-founder of the small-cap biotech research and trading site Chimera Research Group and operator of PelzOptions.com. Pelz currently resides in Denver, Colorado where he trades for his own account.

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