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Getting a Read on Options

Our expert Steven Smith gives you four areas to key on.

This week I'd like to focus on simple ways to identify the nature of option activity and some ways it can be used as predictive tool.

Many readers wonder how I know, or on what basis I can back up a statement, regarding whether a trade is a buy or sale and what it might mean. Check out this query from Xueming T., who asks:

How do you know the number of shorts and longs or the percentage of them for each strike price?

First, let's be clear that for every option buyer, there is a seller. Remember, an option is a contract between two parties that agree on awarding and abiding by the purchase and accompanying sale of the underlying security at a given price within a given time frame.

Unlike a stock in which there is a limited number of shares available to trade, the number of option contracts that can be created is unlimited.

Unlike the underlying stock, in which a rise and fall in price can create or destroy value for all involved, options are a zero-sum game. That is, come expiration the option will have a specific value (potentially zero), and the amount of money made in a specific contract will equal the amount of money lost in that same contract.

In terms of deciphering any meaning from the action, that becomes a combination of art and science. The science or factual part of basic reporting on option transactions is fairly straightforward and easily accessible. This segues to the next question, from Michael, who asks,

What options tool(s) do you use to spot a large block options trade like the ones you often mention in your columns?Thanks. Michael

These are the four main items you want to identify:

1. Volume or the number of contracts traded on any given day. This can be found anywhere from the Yahoo! Finance page to any number of financial Web sites such as our own

, to almost whatever brokerage firm you use, to paid sites such as Bloomberg.

2. Compare this volume to the prior open interest in the strike. If daily activity exceeds the prior open interest, it's safe to say the activity is the initiating of a new position. Again, to find the prior open interest, one can use the same resources. For example, the other day more than 5,000 calls traded in

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in strikes that had no prior open interest. In this case, it was safe to say that at least a part of the volume would translate into a new position.

3. Determine if someone is buying or selling. Despite the fact that for every buyer there is a seller, you want to focus on which party initiated the trade. This is where art enters the equation, but it's good information and can provide a clear picture. The first step is to look at time and sales. Again, this can be found at the above sources, but I'd lean toward your broker, anyone from OptionXpress to Schwab makes this a standard part of its option chain information.

Bloomberg and some other paid services ensure accuracy and timeliness. Time and sales data will show how many contracts traded at a specific price and a specific time. If the transactions were mostly executed at the offer price, it is safe to assume that most of the activity is being initiated by buyers. This will also make itself known by changes in implied volatility. If the initiating party is the seller, then the transactions will have been done at the bid, and there likely will be a decline in IV.

4. This may seem obvious, but look at current or upcoming news events. Are their upcoming earnings? A court ruling? Is the stock confirming the option activity -- that is, is call buying being accompanied by a raise in the share price, or is this a hedge? It's possible it's something as simple as a covered call, in which what might seem heavy selling of calls or a bearish activity is really part of a bullish position.

That said, no one except the participating parties can know for sure what any given transaction represents or if it will prove to be a contrarian indicator or smart money establishing a fresh position.

Now comes the real art, which only comes through time of tracking the trading patterns of the stock and its options to be able to determine what the activity represents.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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