"Options are for degenerate gamblers and pie-in-the-sky speculators."
"The masses are always wrong."
"Go against the crowd."

These are some common refrains heard from many investors who use option activity as a contrary indicator. The most common application uses broad market measures such as the put/call ratio and volatility index (VIX) as gauges of investor sentiment. While interpreting data in this light is certainly a valid and often useful tool (something I discussed in this previous column ), there are also situations in which activity in the options pits can accurately predict or presage an impending move in the underlying stock.

Contrary readings are predicated on the belief that prevailing investor sentiment -- revealed through price, volume and open interest configuration -- is often wrong, while the predictive approach toward options activity says that sometimes this information actually divulges what the "smart money" is doing, and is therefore correct. The challenge is distinguishing the latter from the former.

Contrary indicators are typically used to identify a significant change in price direction; the buy and sell signals are usually generated when readings hit extreme levels in reaction to an identifiable event. Predictive options activity (which might provide a "tell") is characterized by above-average option activity and a change in implied volatility for no apparent reason. Using options as a predictive indicator is more effective when applied to individual issues rather than to broad indices or the market as a whole.

The Price Is Right

One the first steps in using options as a predictive indicator is to appreciate the level of sophistication and knowledge of professional traders and the market makers. The most obvious and easily measured data point to illustrate this is price, reflected specifically in the implied volatility applied to a given option. "If implied volatility is high, there is usually a good reason," said Tom Hough, a market strategist with PTI Securities.

For example, Rambus ( RMBS) was trading around $25 last month, prior to an important court decision. The front-month options were sporting an implied volatility of 130%, with the value of the at-the-money straddle priced at $6 with just five days remaining until expiration.

This indicated the market was anticipating a move of about 25%, with the $19 and $31 representing the straddle's break-even points. After a ruling that was favorable to Rambus, shares closed $6.50 higher. This suggests that the valuations assigned to option prices often accurately reflect future movement in the underlying stock price.

Getting Confirmation

But since volatility is nondirectional, meaning it reflects the probability and magnitude of a price move but not its direction, it can't be used by itself as a predictive indicator. "In assessing the validity of an option's predictive value, I like to see confirmative action in both the underlying stock and technical readings," said Larry McMillan, president of McMillan Analysis.

Surging call volume, for example, without an accompanying increase in the underlying share price or a technically constructive picture, shouldn't be viewed as a predictive indicator.

However, above-average option volume is one of the most obvious flags for identifying predictive action. But you need to look further at that activity.

Large block transactions, which are indicative of institutional trading, are obviously more noteworthy than many small trades. Similarly, outright purchases or sales are better tells than spreads or hedging activity.

One way to discern between volume that is predictive and that which is merely hedging activity is to look for the increase in volume and open interest to spill over into other strikes. "This tells me that the market makers think it's a good play and want to go along," McMillan said.

For example, if XYZ Co. saw an increase in call volume in the days ahead of an earnings report -- most of which would be concentrated in the near-term at-the-money strikes -- market makers would see this as nothing more than speculative buying, without much merit or worthy of consideration.

In this case, the market makers who facilitated the trades (i.e., sold the calls) would look to lock in a small profit by buying the appropriate number of XYZ shares. The position is quickly hedged back to neutral.

But assume there is no pending earnings or news in XYZ, and an order to buy 10,000 April 25 calls hits the market. The market makers might believe this buyer represents "smart money" and decide they want to participate or play along. They would most likely turn to buying call options in other strikes and months to create a position with a greater long gamma (or sensitivity to price movement). This participation would appear in a noticeable increase in the volume and open interest in other strike prices and expirations.

Sometimes implied volatility rises without a signifying event. In this case, a buyer is driving up prices and doesn't mind paying a premium for no apparent reason; this could be indicative of someone having superior information, and it warrants monitoring.

Last Thursday, Electronic Data Systems ( EDS) saw heavy buying of March $20 and $22.50 calls on rumors that IBM ( IBM) might make a takeover bid.

EDS shares jumped some 5%, the implied volatility spiked, and the open interest in April calls increased, indicating spillover activity.

However, the technical picture of its stock price is still fairly negative, and there has been little follow-through buying.

Two other stocks to keep an eye on are Deutsche Bank ( DB) and Apple ( AAPL). Both have shown positive stock patterns and rising implied volatility, while the increases in call option open interest confirm the recent bullish action.

On the other side of the coin, Amerisource-Bergen ( ABC) shares are threatening to break technical support and have seen growing put volume and rising implied volatility. This may indicate that the stock has further to fall.
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.