Tuesday, April 21, 2009

MythBusters- Option Volume







A few weeks ago Options Action took it upon themselves to debunk five common option myths. Let's take a looksie and elaborate...

1. Option volume is a directional indicator
2. Inexpensive options are cheap options
3. Never sell naked puts
4. It's cheaper to let options expire
5. Options are riskier than stock.

I'll tackle myth numero uno today and get to the rest later. The most common way that I've seen traders use option volume is by looking for huge increases in volume (number of contracts traded) in an effort to identify big traders that may "know something", such as a future take over, FDA announcement, or other news events likely to drastically move the stock. In other words, the options market is tipping its hand and hinting at a potential big move in the underlying stock.

First, volume is relative. In other words, high volume for Microsoft (MSFT) options is completely different than high volume for Chipotle (CMG) options. So don't be too quick to think that 5000 contracts, which is most assuredly high volume for CMG, represents high volume for MSFT.

Second, for every buyer there is a seller. Consequently you can't merely look at the total amount of contracts that traded and discern whether they were buying or selling the options. Unfortunately you have to dig a bit deeper and see whether or not they traded on the ask (which implies the options were bought) or the bid (which implies the options were sold).
Furthermore, even if you found out they were bought or sold, the other caveat is you don't necessarily know what strategy they have on. Suppose you find out a big buyer came in and bought up a ton of out-of-the-money puts. While your initial thought would be they're placing a bearish bet, they may actually be bullish by already owning shares in the underlying stock and merely want to buy protection. Or perhaps they were entering a put vertical or calendar spread. Bottom line is it's tough to identify a huge increase in open interest or volume and know what it means. Some traders may enjoy using abnormal volume in their option trading, but it's not really my cup of tea. There's too much other, easier to discern, information I can use.

Third, for every good signal you get from abnormal option volume there are probably two or three signals that don't come to fruition. With all the take over chatter that's out there, you're bound to have numerous abnormal volume trades occuring as people speculate on the rumors, but in reality few big winners really occur. To be fair, I've never really traded off of abnormal options volume, so I have no idea what the rate of success would be or what exactly qualifies a good abnormal volume trade from a bad one. It just seems like random speculation to me.

Bottom Line: There are a ton of other signals I'd use on predicting stock direction before I'd ever assess abnormal option volume.

Tyler-

7 comments:

Anonymous said...

Tyler -
In your piece you said: there are tons other signs you look for the stock movement ( could you mention some of your favorate indicators?

Also, maybe this q doesnt belong for this post, but here it is anyway: Few days back you talked about rolling up the options, but I also came across some folks (mainly the Iron condor gurus) that instead of touching the existing strategy, add another leg to your trade, thinking that market will again adjust itself before the expiry rather than closing out the existing spread and opening up new roll-up.

Any comments?

Tyler Craig said...

Anon,

I keep things pretty simple when it comes to chart reading. My bread and butter is price action and volume. By price action I mean trend, support/resistance, and momentum. I also have a 20 & 50 MA on my chart. I sometimes use ATR (Average True Range).

You'll have to elaborate on the 2nd question. I'm not exactly sure what you mean when you say "add another leg to your trade". What are they adding? A calendar spread or another vertical? I'm quite aware of other adjustment techniques, just not sure which one your specifically talking about.

Tyler-

Anonymous said...

Again, I am new to this options spread strategy, so my informatin maybe (or is) limited, but here it is:

When You opened up a spread of say 138-140 and the market moved against you, so instead of rolling up or closing out the spread the strategy calls for open up a new bull spread for say 142-144.

Again, I will like to know what you think, as the thinking behind thsi strategy is: that maybe market really has run very far and by the OPEX maybe it will be back below 138 level and also by opening up another credit spreadd you can also take advantage of the market movement....anyways, i will like to know your comments if you will

Thanks.

KrengelFamily said...

Tyler-
I am also wondering what your position is in regards to Anon. I believe he is refering to something similar to this:

http://www.condoroptions.com/index.php/strategy/why-adjusting-iron-condors-can-be-dangerous/

This is from Condor Options and refers to what he is talking about under point number 2. "Don't adjust, just add".

Thanks
-Ben

Tyler Craig said...

Anon,
Thanks for the clarification. To me, choosing from the myriad of adjustment/exit techniques for credit spreads (or iron condors) really boils down to what you’re trying to accomplish. My primary purpose in adjusting is reducing risk, not increasing it. Rolling is one such way of reducing risk. Just to recap, the benefits of rolling up (a bear call spread) are:
1. I increase my probability of profit (the short strike is now further OTM)
2. I lower my delta exposure (B/c the new spread has lower net delta)
The obvious disadvantage of rolling vs. exiting would be if the stock continues to rise I could lose MORE money.

I believe you have a typo in your question. You asked if it would be wise to add a “bull spread for say 142-144”. I’m assuming you meant a bear spread (sell the 142 call, buy the 144 call)…. Correct? Assuming that’s the case, then here's my 2 cents.

By adding another bear call spread, if the stock were to retrace and remain beneath 138, then yeah you would make more money than merely remaining in the original call spread. However, you’re not reducing risk (which is my primary goal when the stock has moved adversely) you’re adding more on. By entering more bear call spreads, you are simply upping your position delta, thereby increasing your exposure if the stock continues to rise.

So if you’re comfortable with the additional upside risk, then sure adding more bear call spreads is a viable option. Although you stand to gain more if the market drops you do have more to lose if it trudges higher.

Hopefully that’s what you were looking for… if you have a follow up let me know.

Tyler Craig said...

Ben,

Here are my thoughts in regards to the following comment in the article:

"it’s always better to add another position to your portfolio that takes account of the changed environment, rather than try to “fix” your initial trade...adding position inventory allows you to smooth out your aggregate risk profile."

First off, their original position is an iron condor (put + call spread). Second, when their adjusting I'm assuming their adding another entire iron condor (not just one side of it). So for example, If I originally entered a 70-75-95-100 condor when the SPY were at $85, then the SPY moved up to 94. Rather than closing out or adjusting the 95-100 call spread, I could add a new iron condor with different strikes such as 80-85-105-110.

Because of the different ranges, the odds of losing on both trades simultaneously is a lot less than losing one each one individually. As they said, "adding position inventory allows you to smooth out your aggregate risk profile."

It's definately a viable option - but you could also close or roll up the original call spread in addition to adding a new iron condor. I suppose it just depends on the market conditions at the time I'm contemplating the adjustment.
Tyler-

Anonymous said...

Tyler -

Thanks for your explanation.