Listed options contracts trade on one of seven exchanges. The table breaks down the options volume for each exchange for trading on April 27, 2009. The International Securities Exchange [ISE] and the Chicago Board Options Exchange [CBOE] are the two largest and, on a typical day, account for nearly two-thirds of the overall volume (However, ISE was hit with a system outage Monday and therefore the volume on April 27 is less than normal.). The Philadelphia Stock Exchange [PHLX], the American Stock Exchange [AMEX], NYSE-Arca [NYSE], the NASDAQ [NDAQ], and the Boston Options Exchange [BOX] also list puts and calls.

Source: Options Clearing Corporation (optionsclearing.com)

Millions of options contracts trade on the US options exchanges each day. The record was set on September 18, 2008 when more than 30 million puts and calls traded across the seven US options exchanges. Each year, volumes continue to set records as more and more investors turn to the options market for opportunities. Some are looking for tools to hedge and manage risk, others are speculating on short term moves in a stock or market, and still others use more advanced strategies like butterflies and condors to create a range of different risk-reward scenarios.

Uncovering what strategy another options trader is opening or closing can be enlightening. For example, if a strategist opens a butterfly involving 10,000 contracts, the equivalent of 1 million shares, chances are there was some research done before entering that order. Or, if a put option contract on a banking stock is seeing 10,000 contracts traded, all in orders of 100 contracts or less, it is probably an indication that many smaller investors are worried about the outlook for that bank.

One important indicator of whether investors are buying or selling an options contract is whether the trade is on the bidside or the askside of the current market quote. Like with stocks, the bid is price offer the market is willing to pay for an options contract. The ask is the current selling price. If, for example, I want to buy November 20 calls on Citigroup, the current asking price is $4.55. If I want it filled right away, that’s the price I pay. On the other hand, if I want to sell the price is $4.30. The difference between the two is the spread.

When a lot of trading activity is on the offerside, chances are buyers are initiating the trade. This is true regardless of whether it is a put or call. On the other hand, if the day’s trading is hitting bidside, it is indicative of initiating sell orders. Trade Alert updates us on whether the trade is hitting on the bids and offers. We don’t monitor all of the 1000s of listed contracts ourselves. In addition, if a trade hits between the bids and offers (midmarket) and we aren’t sure, we ask our contacts on the exchange floor whether the trade is being initiated as a buy or sell order.

The buying and selling is then used as an indicator of investor sentiment towards a specific stock or market. For example, if the majority of the day’s trading volume, is calls hitting offerside, it is an indication of bullish sentiment. RedHat (RHT) was a recent example, when volume picked up on October 1. 34,000 calls and 1,300 puts traded on the stock. Nearly all of the call volume was trading on the offer and, as a result, directional sentiment based on the order flow in RHT turned to 94 percent bullish. Short puts, or puts hitting bidside, are also viewed as bullish activity. Meanwhile, put volume traded offerside or calls hitting bidside are considered indicators of bearish sentiment. (Please visit our FAQ section for more on how we track buyers/sellers and bullish/bearish sentiment).

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Cypress Semiconductor (CY) shares are up 3.4% to $9.60, a new 52- week high and have gained some 35% in past two months. Option volume is 5x daily volume as looks like people trying to lock in gains. In July the $10 puts saw buying with 5,105 contracts against just 54 of prior open interest as someone likely using these ITM puts to lock in through Friday’s expiration. The July calls saw the $9/10 spread trade 1,500 times. The later dated Sep. $10 calls traded 5,000 contracts in what looks like opening sale and possible overwriting.

A possible closing seller or over-writer active in Elan this afternoon, with 10,000 Aug 7 calls sold for 52c on the CBOE when shares were trading near $6.93. A buyer paid 75 cents for nearly 10,000 July 1st to open a position and either trade suggests a view that upside is relatively limited in the name, despite occasional deal chatter.

Interval Leisure (IILG) shares are up fractionally to $10.96 but have gained 12% in past two weeks. Option volume 10x daily average as repositioning taking place on the call side. The August $10 trade 2,500 in what appears to be opening even as OI is sufficient to cover. Diagonal spread of the Sep. $10 with Dec. $12.50 traded 1,500 times in what also appears to opening.

Who cares about “what’s trading”? I mean, why do we care what other investors are buying and selling or if they’re bullish or bearish? A lot of activity is nothing more than speculative trading, like buying call options before an earnings report or after takeover chatter affects a stock. In addition, since an options contract is an agreement between two parties, if one is bullish, the other is bearish. So, who cares!

Since a large amount of the daily volume in the options market is by institutions, hedge fund managers, successful private investors, and other experienced traders, the activity often reflects “smart money” trades. Savvy and well-informed investors are the key players in the options market. They use options in a variety of different strategies: not just to speculate, but to create a wide range of interesting risk reward opportunities. Observing their daily activity, not only gives important insight into investor sentiment, but can offer interesting trading ideas that might otherwise be overlooked.

Another important point to keep in mind when looking at order flow is that, while every options contract involves two parties, the trade is often initiated by one investor and, in the absence of another willing to take the other side of the trade, the market maker performs that function.

If, for example, June out of the money calls on Anheuser Busch (BUD) are seeing a lot of opening buy orders, as they were May of 2008, it could be sign that investors are positioning for a move higher in the stock and perhaps a possible catalyst. In BUD, the options activity preceded a takeover announcement and a substantial increase in the share price.

Understanding that much of the activity in the options market is initiated by investors in anticipation of moves (or in some cases no movement) in underlying stocks and markets is a basic premise for analysis of options order flow.

Another premise is that, like the stock market, the options market is very efficient in anticipating future events like changes in the volatility of an individual stock around an earnings report or the possibility that the entire stock market might make a volatile move lower. There are other factors to consider as well, including whether trades are hitting on the bids and offers (discussed in Part II), increases or decreases in open interest (Part III), changes in implied volatility (Part IV), and whether the trading activity is part of a simple or advanced trading strategy (Part V).

Part II will be updated later today. Sign up for the 14-day Free Trial to WhatsTrading.com to read parts III – V on Understanding Options Order Flow.

Lions Gate Entertainment (LGF),which looks like it has a hit with Bruno, shares are up 5% to $6.10 and option activity is 10x daily average with over 25k calls traded to in what looks like across the board spreading. The July $5 calls have traded 7,500 which out strips the 2,100 prior open interest. The January $5 traded 15,000 but there is sufficient open interest to cover. The Sep. 5/7.50 spread traded 3,000 times at an initiating sale of a $1 debit. Overall IV is up some 7% to 74% on the day. This appears to be either someone moving into the short term July and financing it with the later dated paper or just a roll out of the Jan. into the front month.

Fedex options volume running twice normal levels this morning with shares up 2% near 56.66 and premium buyers dominating the flow. Just after 10:30 a buyer paid 1.425 for 1000 August 60 calls, followed several minutes later buy a buyer of 1000 Oct 60 Puts for 6.80.