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How to Decipher an Options Trade

In case you weren’t aware, I write a daily publication called “Today’s Options Market Update” that is designed to identify some big movers or unusual activity in both the equity and options markets. When it comes to stocks, it’s fairly easy to identify big point or percentage gainers and losers, but deciphering options data can be a little bit like playing detective. It’s not only my job to identify and report the facts, but also to analyze the data to help formulate a likely impetus behind the trade so that the information is more meaningful to the reader.

Let me state up front that it is impossible to be 100% certain what the intent is behind each option trade. The primary reason is because we don’t know what other positions (options, stocks, or other) are held by the market participant at the time of the trade and therefore don’t know if it is being utilized as a hedge, a multi-leg trade with an existing position or an outright bullish/bearish stance.

Additionally, we can’t be 100% certain that the volume represents a new position. The main reason for this is because the market participant involved in the trade might have bought and sold the same position (once or multiple times) within the same day and no longer holds the position by the end of the day. Having said that, there usually is enough information to make a reasonable assumption about the intent behind the trade and that is the focus of this article.

Refresher on option basics

Options are contracts that give you the right to buy (in the case of calls) or sell (in the case of puts) the underlying security (stock, ETF, or index) at a specific price within a defined period of time. Similar to stocks, option contracts are traded electronically on exchanges with market makers and each contract displays a bid/ask quote and time and sales information (along with other data). Except for the really actively traded names, option bid/ask spreads tend to be less liquid than stocks.

The theoretical value of the option contract, based on an options pricing model such as the Block-Scholes model, will usually lie somewhere near the midpoint of the bid/ask spread. Lastly, while you can buy, sell and short stocks, there are four actions associated with option contracts – buy to open, buy to close, sell to open, and sell to close. When you buy or sell an option “to open”, this means that you are establishing a new position. When you want to close out a position, you would buy or sell that option “to close”.

When you sell to open an option it is similar to establishing a “short” position on that contract.  Setting the discussion of multi-legs aside (for example a buy-write or spread strategy), if you want to take a bullish stance on a stock, index or ETF you would buy a call or sell a put and if you want to take a bearish stance on a stock, index or ETF you would buy a put or sell a call. 

Call

Put

Buy to Open

Bullish

Buy to Open

Bearish

Sell to Open

Bearish

Sell to Open

Bullish

How do you know if a new position has been established?

There are two primary metrics that are used to help determine whether a new option position has been established or an old position has been closed out – volume and open interest. Volume represents the number of options contracts that have traded on a given day. This figure starts at zero every day and increases in quantity by the number of (opening or closing) contracts in transactions that occur throughout the day.

Open interest represents the number of open option contracts, otherwise stated, the contracts that have been bought or sold to open on previous trading days, and not yet closed out or assigned. The open interest figure starts at zero the day the option contract first begins trading and then increases with each opening transaction and declines with each closing transaction up until expiration of that contract.

The open interest figure remains static throughout the day but is updated at the beginning of each new day to reflect any opening or closing transactions that occurred in the prior day. Since we don’t know whether the option volume on a given day represents opening or closing activity we have to wait until the following day in order to see whether there was any impact to the open interest.

Example

In the example below, you can see that the “Volume” column tells us that 34,375 contracts have exchanged hands so far today. The “Open Int” column tells us that there were 3,039 open contracts coming into the day.. While we don’t know how many contracts out of the 34,375 represent opening or closing transactions, we can assume that most of the activity represents new positions (vs. option “day trades”) and subtract the open interest from the volume and reasonably assume that there are roughly 31,000 opening positions (i.e. – contracts that have either been bought or sold to open):

Source: StreetSmart Edge®

How do you know if the intent is bullish or bearish in nature?

Whenever an options trade takes place both a buyer and seller are involved in the process (and potentially more than one of each on either side of the trade). This is true whether the transaction is opening or closing in nature. Given this fact, what data might we utilize in order to make an educated guess regarding the sentiment behind the trade?

The answer is to look at where the trade took place within the bid/ask spread. Basically all liquid option contracts have a bid/ask spread that identifies the highest price that a market participant is willing to pay to purchase that option contract (i.e. the best bid price) along with the lowest price that a market participant is willing to sell that option contract (i.e. the best ask price). Therefore, regardless of whether it’s an opening or closing transaction, if you want to buy an option contract you will likely need to pay the best quoted ask price and if you want to sell that option contract you will need to accept the best quoted bid price.

Practically speaking however, buy trades occur in between the midpoint and the ask price and sell trades occur in between the midpoint and the bid price all of the time. Therefore, when a trade takes place at or near the ask price we can assume that a buy was initiated by a market participant and when a trade takes place at or near the bid price we can assume a sell was initiated by a market participant. Taking those assumptions into account, we have the following:

  • If the trade occurs at the ask price, or above the midpoint of the bid/ask spread of a call option, and the size of the trade exceeds the open interest, then the option trader likely initiated a long call position and the intent is likely bullish in nature.

  • If the trade occurs at the ask price, or above the midpoint of the bid/ask spread of a put option, and the size of the trade exceeds the open interest, then the option trader likely initiated a long put position and the intent is likely bearish in nature.
  • If the trade occurs at the bid price, or below the midpoint of the bid/ask spread of a call option, and the size of the trade exceeds the open interest, then the option trader likely initiated a short call position and the intent is likely bearish in nature.
  • If the trade occurs at the bid price, or below the midpoint of the bid/ask spread of a put option, and the size of the trade exceeds the open interest, then the option trader likely initiated a short put position and the intent is likely bullish in nature.

If the trade occurs exactly at the midpoint of the bid/ask spread then there really is no way of knowing whether it is bullish or bearish in nature.

Example

In the example below, you can see from the time and sales window on the right that a 5,000 contract trade on the XYZ 06/15/2018 82.50 put took place on the PHLX exchange at a price of $3.40. Given the bid/ask spread ($3.40 x $4.00), we can see that the trade took place at the bid, so we can assume that that the block trader has a bullish opinion on XYZ (i.e. we assume the block trader believes that XYZ will remain above $82.50 at expiration since he/she sold those puts). Additionally, since the open interest on this contract is 88 we can assume that this is a new 5,000 contract position:  

Source: StreetSmart Edge®

How do you know if the trade was part of a multi-leg strategy?

Lastly, the time and sales window also contains various option strategy codes which will help you know if the trade was part of a multi-leg strategy such as a spread, straddle or buy-write.  Below is a table listing the available option order condition codes that will display in the time and sales window:

AUTO

The trade was executed using the exchange auto-execution system

BWRT

The trade was executed as part of a Buy-Write order

CNCL

The trade reported was cancelled

OSEQ

The trade was reported out of sequence

SPRD

The trade was executed as part of a Spread order

STDL

The trade was executed as part of a Straddle order

For example, we know that the trades highlighted in the blue boxes below were part of a spread trade, as indicated by the “SPRD” code next to the time of the trade:

Source: StreetSmart Edge®

Helpful option tools

If the information discussed above or highlighted in “Today’s Options Market Update” interests you, then you will likely find the following tools helpful:

Top movers tab (StreetSmart Edge) – This tab is found on the Trade Tool in StreetSmart Edge and automatically lists the option contracts with the highest volume and biggest % changes on a given underlying security for today. Make sure that you have “All Expirations” and “All Money” selected from the drop-down menus so the results capture all available contracts:

Source: StreetSmart Edge®

Pre-defined screener: high/low put/call volume ratio (Schwab.com) – This tool can be found by logging into Schwab.com and going to Trade->Options->Screeners and then selecting “High/Low Put/Call Volume Ratio” from the drop-down menu. After clicking the “Get Results” button, you will get a list of all of the optionable stocks that have the highest put/call ratio for today in real-time (minimum put and call volume are both at least 100 contracts).

I typically scan down the “Option Volume” column on the results and search through the ones with the highest volume to help identify unusual activity for that day. If you want to get a list of stocks with high call activity simply click on the “Show Low Put/Call Volume Ratio” sub-header shown below:

Source: Schwab.com

Pre-defined screener: large increase in option volume (Schwab.com) – Another pre-defined screener that I like to utilize is the “Large Increase in Option Volume” screener, which can be found a little further down the same drop-down menu. After clicking the “Get Results” button, you will get a list of all of the optionable stocks that have the highest option volume for today, relative to their 20-day average (minimum 20-day average is at least 100 contracts). Once you identify some names that are of interest you can use the “Top Movers” tab on StreetSmart Edge to dig a little deeper into the data:

Source: Schwab.com

I hope that the above information helps give you some additional insight into options trading. If you are interested in receiving this type of information on a daily basis you can check out Today’s Options Market Update. If you are a Schwab client you can sign up for an email alert (Service -> Alerts -> Investing Insights-> Options Trading) to receive notification when that daily blog gets published.

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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options  before considering any option transaction.

Multiple-leg options strategies will involve multiple commissions. With long options, investors may lose 100% of funds invested. Spread trading must be done in a margin account. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Spread trading must be done in a margin account.

All stock and option symbols and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.

Past performance is no indication  of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

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