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.