Understanding Options Order Flow (Part 1)

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.

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