How To Use TM's Indicators: Stocks With Abnormal Call/Put Volume

In this lesson, we will show you how to use TradingMarket's Stocks with Abnormal Call Volume and Stocks with Abnormal Put Volume indicators to spot potentially big movers. Each night, we scan through our universe of companies to find stocks that show significant increases in options volume. Abnormal options volume can often foreshadow events that can lead to big movements in stocks.

The reason for this is that traders who are able to establish large positions in calls or puts, tend to be right more often than the general population of traders. Why this is the case is open to speculation, but that is not as important as the fact that being aware of surges in call or put volume can give options traders an edge. However, be aware that this is a very speculative and high-risk trading strategy.

When a stock's options volume increases significantly, it is often like the calm before the storm. Price action may seem quiet and not reflect any unusual activity. But the huge spikes in underlying call- or- put volume can be the signature for large informed players betting on important corporate events and announcements that can have a significant impact on the price of a stock.

Types of events that would prompt such options speculation might include:

• Earnings reports that are substantially better than analysts' estimates

• Earnings reports that are substantially worse than analysts' estimates

• News involving new products and/ or services

• News involving new contract signings

• News involving FDA approvals

• News involving litigation and court rulings

• Takeovers

If the increase in option volume is in calls, then the news or event will most likely be positive and will propel the stock higher, whereas if the increase in option volume was in puts, then the news will most likely be negative and drop the stock lower. What we are trying to do is to identify and figure out if that increased option volume is speculative in nature.

Therefore, we are not concerned with increased option volume that is due to:

• Arbitrage strategies such as conversions and reversals

• Spread strategies

• Institutional covered call writing

• Institutional protective put buying

We will show you how to screen out option volume due to these types of activities so that you can find abnormal options volume that is of a speculative nature.

Screening out the Arbitrageurs

The Stocks with Abnormal Call Volume and Stocks with Abnormal Put Volume have some built- in arbitrage filtering. You can refine the results further by looking at how much of the options volume is concentrated in one or two series of options.

For example:
ABC Corporation = 50
Average daily option volume = 250 contracts

On the surface, it would seem that something is up, since ABC Corporation's options volume was over six times its average. However, on further examination, we find that the majority of the option volume was concentrated in one series, the November 50 options. Although we don't know for sure, we can suspect that this increase in option volume is due to an arbitrage- type of strategy, such as a conversion or reversal. While we cannot rule out speculative activity, the chances of it being the root cause of the high options volume is not high enough to present a viable trading opportunity.

Screening out the Spreaders

An increase in option volume can also be due to large spread positions such as vertical spreads and ratio spreads. If we suspect that the increase in option volume is due to large spread positions put on by traders, then we can also rule out the increase volume as speculative activity. Therefore, look for increased activity that is concentrated on two series of options. The volume on those two series should be similar.

For example:
XYZ Corporation = 70
Average daily option volume = 500 contracts
Average call volume = 295 contracts

XYZ's call option volume was over four times its average today. You can suspect that something is up. However, on further examination we find that the majority of the volume was concentrated in the November 70 and November 80 calls. This could be due to large vertical spread position and not speculative activity.

Screening out covered call writing or protective put buying

Sometimes, increased option volume is merely due to institutions writing covered calls or institutions buying puts to protect their portfolios from a decline in the overall market. If this is the case, then we can rule out any signs of speculative activity.

For example:
ZZZ Corporation = 41.75
Average Option Volume = 400 contracts
Average Call Volume = 225 contracts
Average Put Volume = 175 contracts

ZZZ Corporation's call volume was over four times its average today. However, we see that the majority of the call volume was in the December 45 calls. Therefore suspect that someone, perhaps an institution is writing a large number of calls, thus this increase in volume is not due to any speculative activity.

Other Considerations

Usually, increased option volume will show up in the front month at-the-money or out-of-the money options. This is because these options will give them the most leverage. Therefore, deep in-the-money option will most likely not be used. In addition, if the front month options have only a week or two until expiration, you may want to look at the next expiring months. Keep in mind that this method is still subjective, since there is no real way to know who bought and sold all of these options. However, we have shown you some tracks that have been left behind which could suggest that a big move is in store. 

Examine time and sales information for signs of institutional activity. For example, a trade of several hundred to several thousands of contracts is usually an indication that institutions are at work.

Kmart Corporation (KM | Quote | Chart | News | PowerRating)

On Aug. 24, 2001, Kmart Corporation showed up in our Stocks with Abnormal Put Volume indicator. Put volume on Kmart was over 20 times its average. Upon examination, we did not find any red flags that suggested that the increase in volume was due to activities such as arbitrage, spreads, institutional covered call writing or put buying. The majority of the volume was concentrated in the front month Sept. 10 puts and the Dec. 10 puts. One week later on Sept. 6, the company reported disappointing August same-store sales, which drove the stock down over 38% in a week!