The options markets gave a great heads-up that a deal was brewing for First Data ( FDC), and I noted that last Wednesday there had been a surge in call activity and suggested that options activity was speculative and that it indicated a buyout bid that would have a 25% price premium.

Jim Cramer picked up on that, too, providing further evidence that something was brewing when he noted on Friday that people were still buying calls hand over fist that day even as the stock fell in sympathy with competitor Global Payments ( GPN) after that company reported disappointing earnings.

So while I like reveling in the light of being right, there is a question we should address: How does one identify what is simply unusual activity from something that is a tip that smart money is at work? Here are some basic criteria for separating the wheat from the chaff and, more importantly, identifying what options might deliver good returns and how to avoid chasing the activity that ends up being useless noise.

Volume and Volatility

First and foremost, look for an increase in call activity and an increase in open interest. More specifically, the volume should be at least three times the average daily volume, focused on near-term options and one or two strike prices.

Make sure the volume is not the result of a spread trade (the simultaneous purchase and sale of similar options but that have different strike prices or expiration dates). A spread is a much more neutral trade than the outright purchase of call options. Checking times and sales will reveal if these trades are outright purchases or part of a spread.

In the First Data case, not only was most of the activity outright sales, but there was also very little put volume. Four calls traded for every put, which also indicates it was bullish rather than hedging activity.

(You can check daily volume on the option chain provided at most brokerage firms' Web sites, or if you are willing to wait until the next morning, you can find free delayed data at the Options Clearing Corporation Web site.)

Implied volatility, or value of the option, should increase even if the price stock does not. This indicates that the buyer does not mind paying the extra 10 cents or even 20 cents, which on a $1 item is a huge percentage premium to gain the leverage of options. Even though options offer an unlimited supply, unlike with stocks that have a limited number of shares, if demand is greater than the desire to sell, then price will increase.

This rise in IV reveals the level of demand for the option. It will also give you some sense of just how large a move one expects or is needed to turn a profit. The rule of thumb is to add the premium paid to the strike price plus another 10% to arrive at what speculators think is good take-out value. Also, read analyst reports to get a gauge on takeover valuation.

The volume should occur in large blocks of 100 contracts or more. This would suggest institutional buying, rather than retail customers trying to find the next hot stock. I hate to say it, but the institutions tend to be the smart money.

Look for spillover into other strike prices. Market makers typically take the other side of the trade -- that is, they would be selling calls to facilitate the transaction and then immediately hedging or offsetting their position through the underlying stock to remain delta neutral. In this case, that would mean buying stock against the calls they sold. But if they think the buying is smart money, they may choose to hedge using other options. In this way, you would see a spillover into the purchase of other calls on option strikes.

By using options as a hedging vehicle, the market makers, who also tend to be smart money, are using the leverage of options to endorse or buy into that whoever is gobbling up these calls seems to have an inside line on upcoming positive information about the company in question. In the First Data case, you saw the buying in April options spill over into May and open interest in the calls increase even as the stock price moved fractionally lower.

The option activity takes place in absence of any known or substantiated news event, such as an upcoming earnings report. First Data is slated to report earnings on April 19, just one day before the April options will expire. Buying options three weeks prior to an earnings release would be a very premature way to play on earnings. The time decay over the next three weeks would be a heavy headwind that would require the company to deliver a blowout number for those calls to turn a profit.

To view a quick video breakdown of how to hunt out unusual activity, click here.

Buyer Beware

But beware that, as I discussed in this article , technology has made the job of sussing out unusual activity a lot easier but its application much more difficult. Electronic trading allows parties that might be privy to, or have a hunch about, a possible takeover to execute a fairly large option order quickly and, more importantly, anonymously. In the past, when orders needed to be worked in person on the trading floor, not only did it take longer to execute the transaction, but it also was transparent as to who was doing what.

For example, was the trade truly an outright new purchase of out-of-the-money calls as opposed to a spread or liquidation? This made unusual volume a more valuable and reliable tool for identifying takeover candidates or stocks in play, but the information was confined to a small group of people.

Now, with intraday activity disseminated in real time, it's much easier for almost anyone to use basic software or simple tools to screen for unusual volume. The problem is that as people start piggybacking on the transaction, the volume swells further and draws even more people into what might not be a predictive or valuable trade.

In less-liquid issues, a simple newsletter recommendation that has nothing to do with a takeover can suddenly spark a buying frenzy, and the stock is in play. And given that takeovers and private money buyouts have come with increasing frequency and are probably the biggest driving force for big price moves, a list of names with "unusual activity" can run to 20 or 30 a day. Clearly, the majority of these will not be takeovers or even profitable trades.

So, given the huge possible returns, it only takes one good winner to pay for the multitude of losers that never pan out. And many people still think it's worth it to chase down unusual option activity, however slim the evidence. But always remember the old caveat: buyer beware.
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; click here to send him an email.

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