The Myth of “Unusual Option Activity” (Part 1)

The financial media often treats unusual option activity as a predictor of how large institutions are trading. This may or may not be very misleading, which in my view casts doubt over the entire strategic approach.

Traders will sometimes study the option flow for a stock because they believe this helps them to understand sentiment. Particularly when a stock is extended, some believe option activity can offer predictive signals. For example, if one large block is going against the trend, it can mean the institutions are starting to think trend reversal. On the other hand, increased small-lot activity in the direction of the trend conveys a message that can fool the beginning trader.

What options are predictive of trend persistence versus trend reversal is not at all obvious. For example, heavy put volume on a beaten down stock could be a trader(s) shorting puts in expectation of mean reversion: either reversal to the upside or at least a temporary reprieve before the downtrend resumes. If this trader(s) is also shorting stock against the put sale then the overall position is actually bearish rather than bullish. The trader(s) took advantage of the high implied volatility to collect some extra premium in the hedge but the primary profit generator is downward stock movement (upside has unlimited risk).

Married puts and covered calls are two other examples of misleading option activity. Buying puts in the former suggests a bearish position but having purchased the stock, this is really a bullish position with downside protection. Selling calls in the latter suggests a bearish position but having purchased the stock, this is also a bullish position with [limited] downside protection. In fact, if the stock is purchased before the option is traded then the stock price may be higher to allow for a cheaper put purchase or more expensive call sale: both advantageous to the combined position.

I will conclude with the next post.