How To Trade Unusual Option Activity

How to trade unusual option activity

There is no ‘secret’ to becoming a profitable trader and you should be skeptical of anyone who tells you otherwise. That being aid, the techniques I’ve outlined in this text served me very well in my trading career and without them I would not have made the money I did.

Reading order flow and watching unusual options activity continues to be one of my most profitable techniques, just like it was on the trading floor.

The Unusual Options Activity Trading Plan

I had two very profitable years in Apple stock when my net profits in AAPL were over a million dollars. Once a week for a year, a Merrill Lynch broker would walk into the pit and sell AAPL put spreads. His acronym was ‘HES,’ and whenever I would see him coming I would know to get long and sell volatility.

How did he know?

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No clue, but by watching him I made quite a few profitable trades.

By combining order flow with technical indicators like the Ichimoku cloud, I devised my OCRRBTT trading plan to trade profitably off of the floor.

The OCRRBTT Trading Plan

Pronounced “Oak Ribbit,” this trading plan will give you a step-by-step method for breaking down unusual option activity.

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After evaluating unusual trades with this plan you will be able to decide if you want to follow it or ignore the trade altogether. The letters in the acronym stand for open interest, chart, risk, reward, breakeven, time, and target. Here you will see the importance of each of these elements in the plan.

Open interest: The first thing you need to look at is if the trade volume is bigger than the current open interest in that line.

If it is this means that this is an opening position and is worth taking a look at. You don’t want to buy an option on unusual activity if it is really just paper covering a short.

Scan the entire order flow, from every option exchange in the U.S

Only consider trades where volume is greater than open interest.

Chart: This is the second most important element of the plan. Once an unusual order is confirmed to be an opening order you must then look at the chart of the underlying stock. You need to ask questions. Is the stock in a strong bullish or bearish trend?

Not All Unusual Options Activity Is The Same

Is there support or resistance at the strikes the institution is trading? Is it more likely they are speculating on more upside or downside or could they be hedging?

How to trade unusual option activity

The answers to these questions will help you determine if the trade is speculation or a hedge. This will keep you from trading against the institution when you actually want to trade with them.

Risk, Reward, and Breakeven: Once the direction of the trade is determined you have to evaluate if the risk vs.

reward profile of the trade the institution executed is in line with your risk tolerances.  Some trades they take could be far too risky for the average retail trader.

How to Find Unusual Options Activity

However, since you know the direction the institution is betting you can tailor a trade that has the right risk setup for you.

The risk of each trade must also be measured against the potential reward.

How to trade unusual option activity

If the institution is risking $5 to make $1 this is a trade you would want to avoid. You should also always be aware of the breakeven of each trade. If there is significant support or resistance at the breakeven point you may want to consider another strategy.

Time and target: Always be aware of potential catalyst events that might be near.

You want to know if paper is playing the overall direction of the stock or if they are playing a near term catalyst event like earnings, drug announcements, or new product launches.

How to trade unusual option activity

This might factor into your decision to take the trade or not. Once you have your time horizon set you want to pick a profit target. Are you leaving this trade on to expiration? Taking off half at a double and letting the rest ride? Knowing the answers to these questions on the onset of the trade make it easier to manage going forward.

Putting the Plan to Work

Once a trade hits the tap a trader must use the OCRRBTT trading plan to analyze the setup and determine if it represents an actionable trading opportunity.  Let’s look at the example below and determine if it is a trade setup that we actually want to take.

How to Find Unusual Options Activity

This order hit the tape on July 7th 2016

To make a determination on the suitability of this trade setup we must evaluate this trade using the OCRRBTT Trading plan.

Open Interest: Was this an opening position?

This trade is labeled opening so there is no doubt it was an opening position. If for some reason the trade was not labeled opening we would still be able to confirm that it is because the volume of 2,749 contracts is greater than the current open interest in the line of 0 contracts.

How to trade unusual option activity

With open interest smaller than volume there are not enough open contracts in the line for this to be a closing trade. It is confirmed opening.

Chart: Does the chart indicate this trade is more likely to be a hedge or a speculative bet?

We need to conform that the underlying trend of the stock supports this as a speculative bet.

How to trade unusual option activity

If it does not the trade may be a hedge and it is less likely to be actionable.  To do this we will use an indicator called the Ichimoku Cloud. It may look intimidating but for this purpose a trader only needs to know that anything trading above the shaded area on the chart is in firm bullish territory and anything below it is in bearish territory.

Here is the chart of SODA on the Ichimoku Cloud the day these calls hit the tape:

We can see that the stock is trading above the Ichimoku Cloud and is an established bullish trend.

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This does not confirm with 100% certainty that this order was indeed a speculative bet but it makes it far more likely that this is the case. With the trend supporting the idea of this trade as a speculative bet we will move on to the next part of the analysis.

Risk and Reward: Does the potential reward justify the risk?

This is an outright call buy and a trader knows that they can never lose more than $0.40 in this trade. This translates to $40 in risk per one lot with what is a technically unlimited upside reward potential. This sets a trader up for a good reward to risk setup and a trader can take this trade.

Breakeven: Where is the breakeven point in this setup?

What is Call Option Volume?

These options are just out of the money and are being bought for $0.40. At that strike price that would make this traders upside breakeven $25.40, or about 19.4% higher than the stock’s price at the time of the trade.

[TRADING] Option Trading Tips - Unusual Option Activity - How to Trade For Traders - ThinkorSwim

This is a large move to the upside, but is not an unreasonable move for a stock like SODA considering the amount of time left until expiry and the earnings catalyst that this expiration captures. With that in mind the setup becomes even more attractive.

Time and Target: What is the trader expecting?

In this trade they are looking for a move to the upside of at least 19.4% by August expiration.

When It Comes to Unusual Option Activity, You Can Believe It or Not

Since the trader bought the Aug 25 calls we will buy the same ones. A trader should never trade a different expiration or price target than the institutional trader.

Remember, they have better information than us.

Everything about this trade sets up well. All of the evaluations in the OCRRBTT trading plan point to this being an actionable trade setup.

The Result

This trade ended up being a fantastic winner. The stock ripped higher in that session and continued to the upside the next day.

The stock ripped to the upside and these options exploded in value.

Anyone looking at the reaction in the stock might be surprised by the huge move to the upside but for those paying attention to unusual options activity were alerted to this potential move before it happened

The options that the institutional trader bought saw an enormous move to the upside trading as high as $1.50 in the next day’s session..

Look at a chart of the options below.

A retail trader who followed this trader with a 20 lot of these options would have profited $2,200 at the highs on only $800 in total risk. This is a perfect example of how a retail trader can harness the power of institutional order flow and trade more like the biggest and most successful hedge fund managers in the world.

The Special Offer:

AlphaShark Trading’s founder and CEO Andrew Keene spent over a decade trading on the floor of the Chicago Board Options Exchange before the rise of computerized trading forced him ‘upstairs’ to trade from the screen…

Chicago is littered with stories of traders who left the floor, only to give most of their profits back while trying to trade from their computers…

Determined not to be one of these cases, Keene put his mind to learning technical analysis and shortly after found himself making money trading from a retail account, off the floor.

In his new eBook, Keene breaks down the history of his most successful trading strategy to date, and outlines a step-by-step trading plan anyone with a trading account can follow.

In his best-selling eBook “How To Trade A Small Account To A Large Account With Stocks And Options,” Andrew explains:

  • What is Unusual Options Activity and Why is it Important?
  • How Does a Trader Identify Unusual Options Activity?
  • How Can a Trader Determine If a Trade is a Speculative Bet or a Hedge?
  • How Can a Trader Use Unusual Options Activity to Identify Opportunities?
  • What is the Best Trading Plan for Trading Unusual Options Activity?
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About the author

Prior to founding KeeneOnTheMarket.com in 2011, Andrew Keene worked as a proprietary trader at the Chicago Board Options Exchange.

Keene graduated from Botta Capital’s clerk-to-trade program to become known as one of fasted traders to ‘make a market.’ As a market maker he traded options in over 125 stocks, including Apple, General Electric, Goldman Sachs, and Yahoo.

Keene left Botta Capital to co-found KATL Group, where he was the largest, independent on-the-floor Apple trader in the world.