As many of my followers know by now I monitor the options market for large Institutional trades or unusual trading (5X+ daily average) in a stock’s options.  I field a lot of questions about this style of trading and wanted to write up an overview to better explain my methods.  This is in no way going to be formal, nor aimed at novice traders, but it will be something I can reference people to in the future.  I am going to structure it in a Q&A format based on previous questions I have seen and can always add to it in the future if there is something I miss.  This is a method I have mastered over the years and could write a 500 page book on it, but will try to hit the main points here without giving away too many secrets.

Everyone has their own methods of trading and it is not worth arguing that one method is better than another, it is different for each individual.  I have found a lot of success with this unique style and find it to be the single best way for idea-generation.  With that said I think everyone should at least want to know where the “smart-money” is positioned in the options market before taking a trade, and it is important to keep an open mind and include options order flow with your technical and/or fundamental view of a stock.

What is the rationale behind following options order flow?

I utilize the unusual and large options activity as a tool for idea generation.  Even on days when the market appears slow there are always exciting traders happening in the options market, and for the most market the hot options action leads you to the stocks that are going to make a move.  The idea is similar to equities where you want to be buying stocks that Institutions want to own, and selling stocks that Institutions do not want to own because the large money traders control the majority of movements in the market, whether it be a Hedge Fund, High Net Worth Trader, or Money Mgmt. firm.I tend to think of it in the following manner:  Institutions have the best access to companies and the best tools to analyze technical, fundamental, and other factors that determine a stock’s future price move.  Therefore by being able to see where the “smart money” is positioning I am able to piggy-back on their research and analysis without having to spend the money or time to perform an in depth analysis of every stock.  Like it or not, if you are trying to buy stocks that Institutions are looking to sell, or short stocks Institutions are looking to buy, you are going to lose.

Of the 2,000 US stocks trading 100,000 shares a day, over a $300M market cap and are optionable Institutional ownership is as follows: 75% of stocks have 60% or more Institutional Ownership, 66% have 70% or more Institutional Ownership, and 50.75% have 80% or more Institutional Ownership.When it comes to looking more at unusual trading rather than large trades the line of thinking is a bit different, and somewhat dark.  The simple fact is that the market is not efficient when it comes to information dissemination and there will always be cheaters.  A lot of the time small-time traders come across certain nuggets of information that will materially impact a stock’s price, and are smart enough to utilize the options market to leverage their trades and make larger percentage gains.  It also touches on Insider Trading, which remains fairly rampant, as does the lack of firewalls between the Research and Trading arms on Institutional desks where I frequently see unusual options activity right ahead of an upgrade/downgrade.

What are the important variables when looking at options order flow?The basic premise behind order flow is that you are looking to see whether option contracts are being traded on the offer (bought) or the bid (sold).  You can also look at the bid-ask spread and compare it to where the order executes in time and sales to see the aggressiveness of a trader to want to get into a position.  Often on the more illiquid names bid-ask spreads may be more than $0.50 wide and if a trader is paying the offer he/she is either foolish or has a lot of conviction the stock is moving higher, and if done in large size it is usually the latter.It is also important to watch the resultant volatility movements when option orders are coming through as generally aggressive buying of contracts will send Implied Volatility higher, specifically in the month where the action is hitting.  On the other hand when a lot of size is selling on the bid Implied Volatility tends to take a dive lower, and this is rather self-explanatory.One rebuttal I often receive is that there is always someone on the other side of a trade.  Well, yes, but that completely misses the point, and this is about what and how much a trader is willing to pay to get into a large position, which inherently is a measure of conviction.  Furthermore, the other side of the trade is often a market-maker who will be on the other side of the options trade, but hedge off Delta-risk in the underlying stock, and therefore is not taking on directional exposure, but the Institution is in fact making a directional call.

Does it pay to always following the large options order flow?

No, there is not a sure-fire way to make a profit every time, but over time I have proven that it is a very effective method of catching large moves very early on, and it also depends on your planned timeframe for trading as often you can catch a quick 30% move intraday and take profits without riding out the position with the Institution.Today along in the Options Hawk Trading Hub chat for subscribers I noted hot MolyCorp (MCP) call buys of the August weekly $10 calls and then waited for an intraday trend break.  The calls were trading $0.40 and closed the day at $0.80.  Also today in Juniper (JNPR) I highlighted October $19 call buying at $0.65 and those closed the day at $0.92.  There are opportunities like this every single day.Also, Institutions are also wrong sometimes, so not every trade is going to work-out, it is a market after-all, and there are no guarantees with so many unforeseen factors in play.

I try and update some Highlights on my site as examples https://www.optionshawk.com/cms.php?page_name=Highlights

How do I know which ones are best to follow?

Generally speaking the larger the trade, the better probability of it becoming a winner because as noted before it shows the amount of conviction and I often refer to those as “High-Impact Trades”.  Also, a trade that involves more risk, such as a bullish risk reversal, tends to be one that is very confident and are often the best to follow.  Another secret that over the past two years has an amazing success rate and large profitable trades are to watch for large put sales in Biotechs, a trader willing to be long stock, effectively calling a bottom.  A few recent examples are PCYC where I started to see this with shares at $8, now at $66.67 and ARIA at $6, now at $20.30.  As a bonus for reading a few recent put sale names in Biotech include LGND, EXEL, THLD, and IMGN off the top of my head.

My method involves not only wanting to see bullish or bearish order flow, but also having the order flow’s directional view align with my fundamental and technical analysis view on the stock.  I have a great background in both fundamental and technical analysis, so the options flow is used as the confirmation factor on my view  to initiate a position, and when all 3 factors align I usually am left with the highest probability directional trades.

Since I have created a ton of tools and have a great memory I often do not jump into a trade the same day that I see the large trade, but instead will wait for the stock to either break past a key resistance level or fall back to a support level where I can enter the position at a better price than the “smart money”.  I always have past order flow in the front of my mind daily when scanning through stocks so I know which ones I want to get involved in.  Over the years I have found that the large options order flow works out a lot more often than it does not, but the timing of the trades are rarely perfect, which can be said for most people, so it rarely is necessary to chase a trade right away.

What are some other considerations when analyzing order flow?

Spreads – Many option traders are done in spreads with vertical spreads most common, but also see butterfly spreads, ratio spreads, 3 way spreads, risk-reversals, synthetics, and more.  Overall the analysis is the name when determining how the spread is positioning.

Hedging – A lot of Institutions use options to hedge and it is not always a perfect science when analyzing order flow, but you can put the odds in your favor.  First, if an option block trades as a fresh buy-write, synthetic, married-put, etc. I can determine this with the time and sales of the equity blocks.  However, often option trades are hedging former holdings so there are a couple of factors I look at.  If a stock is in a strong uptrend and I see put buying I am not going to automatically jump onboard as I can understand the desire to own puts to protect profits.  Instead I will set an alert for a break of a key support/trend level that would spark my interest in owning the puts.  And vice versa, if I see call buying in a name in a downtrend I often will wait for it to break above a key resistance level, unless I have a great fundamental reason town.

Also I always take into account the short interest and more specifically the recent changes in short interest.  If short interest is climbing and I am seeing call buying I have less confidence in the action as the call buys are more than likely protecting short stock positions.”Hidden Spreads” – A block of calls bought is not always bullish if tied to short stock, actually that makes it a synthetic long put, and the same applied to a block of puts bought not being bearish if tied to long stock because that makes it a synthetic long call position.

Ex-Dividend – Liquid stocks will see heavy ITM call active ahead of ex-dividend dates in an arbitrage strategy often called dividend stripping.  I cast aside this action as it is not directional and can only be efficiently replicated by large institutions.

Catalysts – One of the most important things to pay attention to is upcoming events that can cause a move so you can really dig into the reason of “why” the trade is being made.  It can be FDA Events, Earnings, Analyst Meetings, Retailer Same Store Sales, or other events.  Sometimes it takes a bit of creativity such as when Homebuilding stocks see unusual action ahead of New Home Sales or Pending Home Sales economic releases, or unusual action in Gold or Treasuries (TLT) ahead of a Fed announcement, or even names that will move in sympathy to other names that have upcoming events.  It often takes a lot of research and digging, but is important to know.

How can someone follow order flow?

There are a variety tools to utilize and mainly you need a source of time and sales data whether it be directly from the exchange, via your broker (ThinkorSwim now offers time & sales on options trades), via Bloomberg’s various functions for those via terminal access can use TSM (Trade Summary Matrix), or with a programs offered via Trade Alert or LiveVol.

It also helps to have floor contacts at the CBOE, ISE, PHLX and AMEX where many of the trades take place.Many analyze the activity incorrectly and can lead to the wrong trade like in May when I had a back and forth on Twitter regarding what I saw as a large put sale in Weyerhaeuser (WY) as bullish, but another (will not mention the name) suggested it was a bearish put buy because he did not look at the resultant movement in the implied volatility.  Since May, Weyerhaeuser (WY) shares have climbed to $24.60 from $18.

It takes years of experience and there are a lot of intricacies to this “art”, so the best way is to look into the subscription services I offer at Options Hawk that focused on analyzing order flow to come up with trade ideas, and also offers a lot of additional services with tools I have created.I am always innovating and have recently created an Options Expiration Pin Excel Sheet for designing trades around expiration trading, an Excel sheet of bullish/bearish existing Open Interest of sizable trades broken down by Sector, and working on an Earnings Factor Model that will help anticipate not only magnitude of moves on earnings, but also the direction.

For those reading this I just opened up access to the August 7th Market Recap Report on the site if you scroll down to that date: https://www.optionshawk.com/cms.php?page_name=Market_Recap_Reports

It is an example of the types of analysis I put out each day.I hope you enjoyed the read, learned something, and maybe generated an interest in this style of trading!Please leave comments if you have questions on anything I missed and I will try and answer in due time.