Spotting Unusual Activity in Options

It's hard to prove the fire behind the smoke of curious options volumes.
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Steve:

Someone had to know about the merger between Charter One and Royal. The odds are that someone told a family member who was greedy and they bought a load of options. That's just my guess. -- T.G.

This reader was responding to some unusual options activity that I noted on

the Tuesday morning after the $10.5 billion takeover of

Charter One Financial

(CF) - Get Report

by

Royal Bank of Scotland

was announced.

With a little more time I was able to provide more details in a follow-up email to the reader. I initially focused on the slug of 1,200 June $40 calls bought on Tuesday, but the unusual activity started the previous week.

On the previous Thursday, 1,600 calls traded against 278 puts. The next day, on Friday, 2,394 calls traded to a mere 40 puts. Then this Monday, May 3, saw 3,468 calls traded against just 398 puts. This escalation of call volume and the accompanying decline in the put/call ratio culminated on Tuesday, when 5,744 calls traded against 470 puts.

To put this in perspective, through the first four months of the year Charter's options activity averaged about 150 contracts a day.

As a result, both the May and June $40 calls jumped from about 50 cents each to an intrinsic value of $4, netting those buyers a 1,000% gain. Was there something illegal going on?

As I wrote at the time, "it certainly smells more of a leak than a lucky speculative play." The exchanges involved (the bulk of the volume was conducted on the Chicago Board Options Exchange and the Philadelphia Stock Exchange) responded to calls by saying they investigate all unusual activity but couldn't provide specifics regarding any current inquiries.

As I see it, it would be hard to prove any illegal activity because the unusual volume occurred over a period of several days across several strikes and expiration periods and was executed by a variety of brokers. Unless someone with direct ties (i.e., company executives, or lawyers involved in the merger, or their family members) was foolish enough make a large purchase with an account in his own name, it would be extremely difficult to show the activity was the result of inside information or illegal.

The reader then referenced an old article of mine on how occasionally

options tell the truth, and asked if there might be some software that should have alerted us to this type of activity. The answer is yes, and I'm sure that as the above-average activity popped up on some traders' screens, it led to more and more call buying. (If you're out there and successfully screened this activity, let me hear about your strategy.)

To be sure, though, this one seems to have passed under many people's radar screens, and most people in the options advice industry, such as Larry McMillan, Bernie Schaeffer, Jon "Dr. J" Najarian (and myself included), were left merely reporting the activity after the fact. "Sometimes you have to get hit over the head with something to notice it," wrote Najarian, the chief market strategist at PTI Securities in his newsletter on Wednesday.

Tom Hough, also with PTI Securities, noted that because Charter One Financial is far below the top 500 stocks in terms of trading volume for both its options and underlying shares, it's not a name that many large traders would automatically be screening for unusual activity.

That doesn't mean that many traders were any less suspicious. Another reader wrote to me that

"if this is not an insider trading leak, I will be a monkey's uncle."

I couldn't agree with that statement more, but I also find an ironic truth in it. As far as we've descended from apes, we've also evolved to find new and more inventive levels of deception. For all of the supposed reforms from Eliot Spitzer's crusading, we still must accept that thieves are cohabitants of the den in which we live.

Hough believes that advances in technology and overburdened investigation and enforcement departments actually might have people believing that it's easier for suspect trading to slip through the cracks undetected.

Steve:What about using a back spread strategy or a straddle with both puts and calls? If I'm more bearish on the market now, then the position that's "right" should be a big win. Or am I missing something obvious that would make a plain straddle the better way to go? Sometimes this makes my head hurt.-- B.R.

You're not missing anything. Almost any strategy can be established in an inverse or mirror fashion. In the case of the

back spread, you would simply use puts to create a bearish position. The risk of getting long gamma (the rate of an option's price change based on a change in the underlying price) on both a bullish and bearish position at the same time is that if the market goes nowhere, the vega exposure and contraction in volatility could result in both positions incurring losses. But I'm sorry to say I have no idea which is the better way to go. I'm sure if whatever you decide is right, your head will feel a whole lot better.

Steve:Thanks for the article on Single Stock Futures. I have heard of these but have not seen any listing. How can I get quotes? Thanks, -- F.F.

There are two exchanges that currently trade single-stock futures and will provide the most comprehensive data for their listing. They are

OneChicago and

NQLX, a unit of Euronext.liffe exchange. Note that on each Web site, the price quotes are on a delayed basis. For real-time trades and quotes, you'll have to pay a fee or have access to an online brokerage account that supplies such data.

Steven Smith writes regularly for TheStreet.com. 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 invites you to send your feedback to

steve.smith@thestreet.com.