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Unusual Options Activity and Implied Volatilities

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Financial news about options often includes reporting about unusual trading activity in a particular option or spread. Many brokers and options analysis products incorporate unusual activity features into their options platforms.

The basic story is usually that options that had previously been very thinly traded suddenly see a big spike in volume. The implication is that someone with knowledge about the direction a stock is about to move uses options to initiate a leveraged position that will profit from that move.

For instance, an out of the money call with small open interest and low volume suddenly sees big buying all at the same time. Subsequently a buyout deal is announced, the shares rally and the formerly inexpensive calls are now in the money, producing a huge profit for the buyer.

Of course, it’s illegal for someone to trade on non-public information and FINRA and the SEC are actually quite good at recognizing when unusual activity preceding a big move was the result of insider trading - and the offenders end up disgorging profits and paying fines. These big trades are more likely to be the positioning of a big firm with good research than the illegal type of "insider" trade.

The typical “unusual activity” trade would be to buy the same options that the big buyer just purchased on the assumption that if a well-capitalized trader or big firm is buying, they must know something valuable and that an individual can ride their coattails to profits by emulating the same trade.

There’s also another way to take advantage of unusual activity. Fade it. Take the other side - at least on the option.

It sounds counterintuitive, but the implied volatility moves after a big trade can shift the odds in your favor.

The option markets respond to big buyers by raising implied volatilities (and to big sellers by lowering them.)

Let’s say there’s a big call purchase observed in the market. If someone buys a large quantity of a formerly thinly-traded call option, the implied volatility on those calls – as well as other calls in that same general vicinity of strike prices – is going to rise.

If you simply buy the same call after observing the big trade, you’re going to pay that new higher price.

If the trade is in a stock that you either own or would like to own, you’re probably better off selling a covered call.

You own the shares (or buy them) and then sell either the same call that the big buyer purchased or possibly one or two strikes higher. I’d look at the relative implied volatilities and choose the strike that was trading at the highest one.

This way you still get long exposure to the stock you want - and that a big market participant is betting on as well - but instead of paying the high price, you take advantage of the implied volatility move and receive the higher option price.

If the big buyer is correct about the timing and direction of the move and the stock rallies through your strike, you’ll collect a quick profit when the shares are called away at expiration. If the big buyer was wrong, you’ll collect the inflated premium on the option you sold, lowering your cost basis on the shares you wanted to own anyway.

So when you see an “unusual activity” options trade happening, consider that sometimes your best move might be to take the other side rather than simply executing a copycat trade.

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