Nathan: Don't Be Fooled by Peculiar Options Activity

This article was originally published at 12:56 p.m. EST on Action Alerts OPTIONS -- a service that offers simple options strategies for stocks held by the Action Alerts PLUS portfolio, a charitable trust managed by Jim Cramer and Stephanie Link.

The financial media often likens unusual options activity to some sort of a tell regarding what the "smart money" is doing. In some ways that is correct, but in certain situations this can be a very misleading idea.

Most savvy traders will take the time to study the options flow for a stock in which they are involved, as this allows them to glean speculative sentiment. In fact, gauging sentiment is probably the main reason we highlight unusual activity, or changes in open interest. Particularly when a stock is extended in either direction, options activity can sometimes offer us telling signals. For instance, if one large block is going against the trend, it can mean the smart money is starting to become contrarian. On the other hand, a great deal of small-lot activity in the direction of the trend can betray when smaller investors are getting euphoric.

However, you should always be skeptical of reading too much into unusual options activity, as this could point to an offsetting position against the actual overriding trade. We've seen this, and done this, multiple times throughout our careers.

Back in the summer of 2008, for example, one hedge fund manager would notoriously sell puts on some of the distressed financial stocks -- like Washington Mutual, now owned by JPMorgan Chase (JPM). However, he'd be shorting stock against those put sales 1-for-1. He was taking advantage of the high implied volatility on the downside to collect some extra premium, but his put-selling activity constituted the directional opposite of his true position in the stock.

Alternatively, we've also often seen large traders buy puts or sold calls against new long positions. One of my favorites was a trader who would buy up his stock position first, and then ask for an offer on puts in that stock. Since he was the one who drove up the stock in the first place, he got a better entry on the stock-and-long-put combination than he would have done if he had traded both together.

The point here is that blindly following the "big" money simply because of large options trades can mean playing a dangerous game. The activity you see could merely be a hedging mechanism against the trader's larger position in the underlying stock.

Options activity, then, is worthwhile to follow -- but only as one piece of the trading puzzle. Traders should be careful about listening to those who tout strategies that do nothing but follow the big prints, using only these as input for initiating a trade. The issue is compounded, moreover, by a confirmation bias on the part of such strategist: You're likely to hear about the ones that worked, and not a peep about the ones that didn't.

So tread lightly here. Don't blindly follow unusual activity in options without looking at other inputs. Oftentimes, instead of following the smart money, you'll be walking blithely into a stampede with the rest of the herd.

At the time of publication, Action Alerts PLUS was long JPM. Dan Nathan had no positions in the securities mentioned.

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