Traders most often use broad market measures like the put/call radio and volatility index (VIX) as gauges of market sentiment -- that is, whether traders are bullish or bearish.

And as measures of emotion, they are most often viewed as contrary indicators. That is, if the masses are extremely bullish, as indicated by these metrics, it could spell trouble and a signal to sell.

Although interpreting data in this light is certainly valid and often useful, 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 to options activity says that sometimes this information actually reveals what the "smart money" is doing, and therefore is correct on its face.

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. Outside of an extremely high put/call or VIX reading, option activity is a more effective predictive indicator for individual issues than for broad indices or the market as a whole.

The Price Is Right

One of the first steps in using options as a predictive indicator is to appreciate the level of sophistication and knowledge of professional traders and 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," says Tom Hough, a market strategist with PTI Securities. (For a list of options definitions, please check out my glossary for the Options Alerts newsletter.)

For example, drug firm Adolor ( ADLR) saw the implied volatility on its August front-month options surge from 50% to more than 115% in the five days prior to the Food and Drug Administration's scheduled July 25 hearing regarding the company's drug Entereg. This translates into expectations for a 20%, or $2, price change, either up or down, within a four-week period.

One quick way to gauge the expected move is to use a thumbnail calculation based on the price of the at-the-money straddle. With Adolor trading at $10 per share, the August $10 straddle (the total cost to purchase the $10 put and $10 call) was priced around $2. After the FDA released a letter providing for "initial approval" of Entereg, the immediate reaction saw shares jumping to an intraday high of $12.20. Sounds like a 20% move.

But as traders delved further into the full release, which included a statement that additional proof of the drug's effectiveness would be required before the company would be allowed to market the drug, the stock reversed course and ended up back at $10 per share.

This is a fine example of options accurately pricing in an imminent move, but it also highlights the nondirectional nature of implied volatility and the difficulty of realizing a profit even if what has been predicted comes to pass.

Options markets have been equally prescient in anticipating earnings causing a price movement with everything from Caterpillar ( CAT) to Amazon ( AMZN) seeing the implied volatility on their options ratchet up ahead of earnings to a level that fairly accurately predicted the resulting move.

Looking ahead, keep an eye on Pozen ( POZN). The drug company reported earnings on Thursday, basically met all expectations and saw its shares remain unchanged near $8.50 per share. Typically, following such an earnings report, the related options would undergo a contraction in pricing as the implied volatility level declined.

But the implied volatility in Pozen's options actually crept higher, to a very rich 108% level.

That's near a 52-week high, and well above the stock's historical volatility of 36% over the past 60 days. Keeping premiums pumped is the anticipation of an FDA ruling on its migraine drug, scheduled for Aug. 4. Because the immediate future of the company rests on the outcome of this decision, it's no surprise the options are pricing in a move of nearly 24%, or $2.10, over the next three weeks.

Getting Confirmation

But because volatility is nondirectional -- meaning it reflects the probability and magnitude of a price move but not its direction -- it can't be used on its own 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," says 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, and you need to look further at that activity.

Large block transactions, which indicate 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 volume that's 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 says.

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 and not 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 report 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 as 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 indicate someone having superior information, sometimes obtained by inside channels or other means -- legal or otherwise -- and it often warrants monitoring.

Several online broker firms, such as ThinkorSwim, OptionsXpress and InterActiveBrokers, supply tools that can help monitor unusual activity and changes in implied volatility. Third-party software is available for this purpose. And while these can often reveal a beautiful nugget that leads to a highly profitable trade, I'd warn against becoming overly reliant on these scans or using them as your sole criterion in making trading decisions.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Adolor and Pozen to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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 appreciates your feedback; click here to send him an email.

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