borrowing.Thus, the following trade takes place as two block trades: (1) the stock beingexecuted probably on a regional stock exchange and (2) the options beingexecuted on the option exchange.Large TraderBuys 60,000 XYZ at 221⁄8(an uptick)Buys 600 July 30 puts at 77⁄8
ArbitrageurSells short 60,000 XYZ at 221⁄8(an uptick)Sells 600 July 30 puts at 7 7⁄8
Net money: $1,800,000 debit
$1,800,000 credit
As long as the position is in place, the arbitrageur is earning interest on$1,800,000. The arbitrageur has risk that the stock could rise above 30, inwhich case it would cost him more than $1,800,000 to buy his positionback. But the large trader will tacitly assure the arbitrageur that the puts willbe exercised before that happens. Note that when the puts are exercised,the arbitrageur’s position is completely closed out: the put exercise causeshim to be assigned—the arb buys stock—60,000 shares at 30.Meanwhile, the large trader begins to sell the 60,000 shares that he islong into the open market. He “pounds” the stock downward until he drawsout other big sellers, at which point he buys back the stock for a nice profit,exercises his puts, and closes out both his and the arb’s positions. This maytake place in as short a period as one day, or it may stretch out a little.There are also slight variations on the order of events that the large trader
USING STOCK OPTION VOLUME AS AN INDICATOR
197
transacts after the arbitrage position is established, but the end result is thesame: the stock goes down.Now, suppose that, separate from all of this, you are monitoring theoption volume of XYZ on that first day and you notice that 850 contractstraded, while average volume was only 250. Furthermore, these contractsare mostly puts, but they have this distribution:OptionSep 20 putSep 20 callSep 30 put
Volume200 contracts (bought by the insider)50 contracts (unknown origin)600 contracts (described above)
If you blindly applied the screen against in-the-money options, youwould ignore this situation; but since puts are involved, a closer look isrequired. If the stock starts to “tank,” you should probably buy some putsyourself, as you can then be fairly certain that whoever bought those 600in-the-money puts is hammering the stock, and you can ride his coattailsprofitably.
The last major screen that is usually applied is one concerningthe expiration dates of the options that are most heavily traded: thenear-terms or the far-terms. For reasons of leverage once again, thespeculators with inside information will buy the near-term options(assuming that they are not too near-term), for these are cheaper inprice and are generally the most liquid contracts. The one exceptionwould be if the most near-term options are going to expire in a matter of just days, then the majority of volume might move out onemonth to the next contract. However, if a majority of the volume isconcentrated in longer-term contracts, then you would have to suspect that institutions are writing covered calls; they often prefer towrite call options with several months of life remaining or to buymidterm puts as protection.As mentioned earlier, the approach of an expiration Friday cancause option volume to increase in many issues. This is becausemany option traders either close out their positions or roll them outto the next month. These activities are again among those that arenot indicative of speculative activity, but are just in the normal courseof events. Of course, such activities will still show up in the initial test
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when you look for stocks whose daily option volume is at least double the average volume.Most option traders who have positions in expiring options willwait until nearly the last trading day—the third Friday of the month—before closing out those positions, although some expiration-relatedactivity begins on Wednesday and increases on Thursday. Thus, theobserver of option volume must allow for this potential increase inactivity when he is applying his screens. On expiration Friday itself,he can literally ignore all trading in the expiring options as havinganything to do with speculation. In addition, some of the volume inthe next month’s options—whatever amount is related to positionsbeing rolled out to later months—is irrelevant as speculation also.On the Thursday before expiration, these same statements aremostly true, although there have been a few cases throughout thehistory of listed options where a takeover did occur on expiration Friday. One of those was Gerber, whose story was related in Chapter 1.Another occurred back in 1987.Farmer’s Group options had been extremely active all day on the Thursdayprior to expiration; moreover, a substantial portion of that volume was inoptions that were expiring the next day. Option volume continued to beheavy on expiration day itself. Rumors were running rampant that atakeover of the insurance company was imminent. But by the time the stockmarket closed, there was no news of the merger. Moreover, when the timehad come to submit exercise notices, there was still no announcement.However, it was not long thereafter that news of a large takeover wasannounced. Thus, it was necessary to monitor the Thursday volume inexpiring options in order to “catch” this takeover.
So, while you can ignore most of the volume in options that aregoing to expire in two or three days as being irrelevant due to expiration, it would be a mistake to be dogmatic and say that all such volume can be ignored. Thus, as expiration approaches, you will havea larger and larger universe to screen. The screening process itselfthus becomes more of an art than a science as expiration approaches. My general guideline is that I will tend to eliminate anysituation near expiration unless the option volume is truly dramatic,probably at least three or four times the average volume. And even
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then, of course, that volume must pass all of the previously mentioned screens.There is another “message” that stock options can give you atexpiration: they can often tell you whether “old” rumors are stillalive. This information can be gleaned by seeing what the option volume looks like in a stock that was recently a takeover rumor, perhapsa month or so before expiration. At the time of the initial rumor,traders buy call options. However, if the rumor dies down, they continue to hold many of these calls all the way to expiration, hoping forthe best. At expiration, they will sell these calls to recoup what theycan. Then, if the rumor is still alive, they will buy calls in the nextexpiration month. So, as an observer of these option activities, if yousee that all of the volume in a recent rumor stock is concentrated inthe expiring options, then you can assume that the rumor is “dead.”However, if you see approximately equal volume in the expiringoptions and the options of the next month, then you can assume thatthe rumor is still alive. Knowing this, you can continue to monitor thestock for signs of a breakout.So, now that we have spent a great deal of time describing whatto screen out, we will show you what a real takeover- (or rumor-)inspired option volume pattern looks like. This is one that we spottedfor the customers of our daily service.On July 26, 1995, Southern Pacific Railroad (RSP) suddenly spurted apoint higher, from 19 to 20, in one day. Option volume was heavy. Nearly2,600 contracts traded that day—almost all of which were calls—asopposed to an average volume of less than 900 contracts daily. Augustexpiration was more than three weeks away, so there was plenty of tradingin the August options. The call option volume looked like this:RSP: 20; July 26ExpirationStrike Price
Aug
Sep
121⁄2 calls15 calls171⁄2 calls20 calls
252201,100
5088580
Nov30
120
200
THE PREDICTIVE POWER OF OPTIONS
Only a few puts had traded: 140 of the Aug 171⁄2 puts and 230 of theNov 230 puts.The strike price of 20 was the highest strike price available. Note thepreponderance of call volume at that strike. That is good. Also, note howthe August calls are the most active at the two highest strikes; that is alsogood. In addition, the put volume doesn’t seem to indicate that much, ifany, arbitrage was going on, since there is very little matching of call volumeand put volume in the same series. Finally, there doesn’t really seem to bemuch, if any, spread activity either; even if all of the in-the-money calls wererelated to spreads against the calls with a striking price of 20 (and they mostassuredly are not all in that category), that would still leave a lot of speculative activity in both the Aug 20 and Sep 20 calls. In fact, it is more logical toassume that the Nov 20 calls and many of the in-the-money calls werebought by market makers as a hedge against the Aug 20 and Sep 20 callsthey were selling to the public.All in all, this is a “classic” volume pattern, and it was justified. Optionvolume remained high as the stock oscillated back and forth around 20 forthe next five days. Then, on the sixth day, the stock received a takeover bidfrom Union Pacific Railroad.
Analysis in Real TimeYou have surely noticed that all of analyses are based on closingoption volume and closing prices. Most of the time, this is sufficient,because option volume will generally begin to significantly increaseat least two days or more in advance of a major corporate newsannouncement. In fact, I am often suspicious of option volume that“springs up” only on the day before an expected announcement,such as an earnings report. However, there have been cases whereoption volume is related to a takeover that occurs the next day. Thus,waiting for the market to close before doing the analysis may costyou some profit opportunities.On December 16, 1994, Caesar’s World options traded nearly 2,500 contracts, and the stock jumped two points. Average option volume was justover 400 contracts, so this increase was significant. The stock had previously been rather dull, trading in a range between 40 and 46, and optionvolume had been quite low for some time. However, the next day, before
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201
the market opened, Caesar’s received a takeover bid from ITT Corporationand subsequently opened 20 points higher!Another significant and similar situation occurred on June 2, 1995.That was a Friday, and Lotus Corporation rallied 31⁄2 points to 321⁄2 onoption volume of nearly 8,200 contracts. Average daily option volume was2,500 contracts. Lotus had been trading down previous to that day, as ithad reported bad earnings a few weeks earlier, and the stock was under selling pressure. Monday morning, before the market opened, IBM announceda $65 a share takeover, and Lotus opened up 29 points at 611⁄2!
Those observers of option volume who only use closing priceswere unable to capitalize on these situations because, even thoughoption volume on the day in question had a significantly speculativelook, the takeover bids were received before trading began the nextday. Although there are only a few of these situations each year, theycan be lucrative to spot if you have the wherewithal to do so.In order to trade these latter situations, you must do your optionvolume analysis in real time, during the trading day. Then, if youranalysis reveals a truly speculative situation, you can buy stock oroptions during the same trading day. Some small adjustments needto be made to the volume screens when analyzing option volume inreal time, during the trading day. The amount by which total volumeexceeds average volume should be lessened, depending on the timeof day at which you are running the analysis. For example, if you arerunning the analysis at noon, you might want to see all situations inwhich the total daily volume is equal to or greater than average volume (rather than double average volume, which is what we look forat the close of trading).Experience has shown that running a real-time analysis about anhour or an hour and a half before the close of trading is appropriate.This gives you enough time to do analysis and still be able to take aposition if you feel one is warranted. The main problem with realtime analysis is that it can lead to buying overhyped late-day situations, especially on a Friday, when rumors are swirling very fast.Therefore, my advice is to be rather stringent on your criteria for taking on a position based on real-time analysis. Remember, mostrumors don’t turn into takeovers the next day, so you’ll normallyhave plenty of time to take a position.
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ExamplesNow that we have gone over the methodology for selecting some ofthese stocks, let’s look at some actual examples. The following onesare all taken from actual trading situations that we identified for customers of our daily fax service in 1994 or 1995.The Southern Pacific Railroad example, whose option data werejust shown, is a good place to start. Review the data printed in thetable on page 199, showing the option volume on July 26, 1995.Figure 4.1 is a price chart of Southern Pacific at that time. Along thebottom of the graph, option volume is shown. The option volumeline looks very “choppy” because on many days, Southern Pacificoptions were not trading at all.
Figure 4.1SOUTHERN PACIFIC RAILROAD
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203
This graph of option volume only tells us the total volume, ofcourse, and does not give us information on the detailed breakdown,which is necessary for the various screening activities that we havedescribed so far in this chapter. Look at the graph of option volumein May 1995. Note the large volume spike (point A). That apparentlywas unrelated to speculative activity, as the stock not only tradedsideways after that, but there was no option volume at all for the nextseveral days. Now, look at the option volume on the graph in lateJuly 1995 (point B). This time the volume spike was speculative innature, with the actual peak coming on July 27, 1995 (one day afterthe volume that we first noticed in the preceding example). Not onlythat, but volume remained heavy for several successive days.The stock traded between 19 and 20 for several days while thisheavy option volume was occurring. Then, on August 3, 1995,Union Pacific made its takeover bid, and the stock jumped to 24 thenext day (the graph only shows the option volume prior to thetakeover bid; there is always plenty of option volume on the day afterthe corporate news is announced). Thus, this Southern Pacific Railroad situation was a classic example of using option volume to spot atakeover just before it was announced. There was a good speculativelook to the option volume for a full week before the actual announcement, so traders had plenty of time to get into the stock.One of the most profitable takeovers of 1994 was the bid forAmerican Cyanamid (ACY) made by American Home Products. Thisone, too, was able to be detected by observers of option volume. Thegraph of ACY during the pertinent period is shown in Figure 4.2.The stock was trading modestly downward with little option volume in January and February of 1994. In fact, it made a low at 43 inMarch, and the first burst of option volume accompanied the initialrally off of that low (point A). The latter half of March had very heavyoption volume, considering that average volume was running at verylow levels in those days. All option volume statistics would increaseas the spring and summer of 1994 passed.ACY traded sideways during April, and option volume once againdropped off to nearly nothing. Then, on May 1, another burst ofoption volume got the stock rolling to the upside. At that time, thiswas the heaviest option volume to date in ACY (point B). This burst
204
THE PREDICTIVE POWER OF OPTIONSFigure 4.2AMERICAN CYANAMID
of option volume proved to be short-lived, but the stock continuedhigher for the month of May, climbing to 53 by month’s end. Then,another day of heavy option trading was recorded (point C).After this once-again short burst of option activity, the stockbacked and filled a little before advancing again in late June and earlyJuly. Finally, on July 11, the stock gapped two points higher, accompanied by the heaviest option volume yet (point D). By this time,takeover rumors were circulating. You can see that the stock workedhigher during the middle of July. But there was a major differencethis time: while option volume backed off some from the point Dpeak, the option trading remained active, trading at levels aboutequal to where they had been at point A back in March.By late July, the stock was trading near 60, and option volumethen proceeded to reach the highest levels ever (point E). On July 29(a Friday) and August 1 (the following Monday), the option volume
USING STOCK OPTION VOLUME AS AN INDICATOR
205
Table 4.1ACY: 63; JULY 29ExpirationStrike Price
Aug
Sep
Oct
Jan
55 calls60 calls65 calls
1005421,189
33315369
45
29
accelerated to extreme levels. Table 4.1 shows the option tradingdata for July 29, but a very similar pattern occurred on August 1.A total of 2,622 calls had traded. A total of 297 puts also traded,scattered among five different series. Average volume at the timewas 697 total contracts. So option volume on this particular day wasabout four times the average. You can see that the “speculative” lookthat we have talked about existed in the distribution of the call volume: most of it was in the near-term, August, options, and most of itwas in the highest strike (65).Finally, late in the day on August 1, American Home Productsmade their bid. ACY was halted on the New York Stock Exchange(NYSE) at 63 and reopened at 91 in the third market. This was a successful culmination to the story for option volume observers. Sincewatching option volume is a short-term trading activity, these traderswere probably in and out of the stock several times during the springand summer of 1994, each time garnering small profits, until the bigstrike in early August.Another 1994 takeover that was signaled by increased optiontrading volume was Gerber (GEB). In fact, the first signs of speculative activity in Gerber were increasing option prices, but that is aphenomenon that we discuss later in this chapter. Figure 4.3 showsthe price history and option volume of Gerber during 1994.Until early March 1994, Gerber was trading in a very tight rangeof 27 to 29 with no option volume on most days. Then, in March,the stock broke out to 33, accompanied by heavy call volume (pointA). A couple of weeks later, the stock managed to move up to 35
206
THE PREDICTIVE POWER OF OPTIONSFigure 4.3GERBER—OPTION VOLUME
intraday, and option volume remained relatively heavy on most days.Rumors of a takeover were rampant; and when nothing happened,traders began to exit the stock. So Gerber fell all the way back to 29by mid-April.Then, on May 6, the stock jumped two points, from 31 to over33, and option volume hit its highest levels ever. This was a clear-cutsignal that the stock was “in play” once again. Table 4.2 shows whatthe option volume looked like on that day. It is another classic example of what speculative option volume looks like in advance of corporate news. Nearly 8,800 calls traded that day, and about 400 putstraded as well. At the time, average daily option volume was 2,770contracts. This tripling of normal volume was an impressive sign thatsomething was happening in Gerber.
USING STOCK OPTION VOLUME AS AN INDICATOR
207
Table 4.2GEB: 335⁄8; MAY 6ExpirationStrike Price
May
June
July
Oct
25 calls30 calls35 calls
781,9094,112
154141,079
40268584
229252
The stock continued to climb higher over the next two weeks,and option volume rose to even loftier levels. The peak price was 37and by Friday, May 20 (option expiration day for the May options),Gerber had fallen back a little to close at 345⁄8. As related in a storyin Chapter 1, the takeover bid was received that night. On Monday,Gerber opened at 51. Much to their chagrin, some option writerswere assigned on (out-of-the-money) May 35 calls.Chipcom (CHPM) was a stock that was on the defensive for muchof 1995; but then it turned—almost on a dime—and option volumeobservers picked up another takeover. From Figure 4.4, you can seethat option volume was moderately heavy in April 1995, when thestock was falling from 46 to 28. Then as it settled in a trading rangeof 32–34 in May, option volume almost disappeared. The companyannounced bad earnings on May 26 and fell 12 points in one day.This caused option volume to surge briefly (point A on the graph).However, the stock began an almost immediate recovery and gotback up to 26 in June, before falling back some. It closed at 26 againon Friday, July 21, and option volume surged. As shown in Table4.3, option volume that day had a speculative look to it as well,although it wasn’t as “classic” a pattern as some of the onesdescribed earlier. A total of 2,014 calls had traded (and 562 putstraded also). This total volume of 2,576 was huge compared to theaverage volume of 280 total contracts per day—more than ninetimes the average.This volume pattern has some slight anomalies in it. First, theheaviest volume is in the September options, even though the August
208
THE PREDICTIVE POWER OF OPTIONSFigure 4.4CHIPCOM
options had four weeks of life remaining at the time. Second, themajority of the volume is in the at-the-money strike (25) instead of theout-of-the-money (30). Both of these facts are slightly different fromwhat you would hope to observe in an ideal situation. Note that therewere not any August 30 calls available for trading at the exchange.Table 4.3CHPM: 26; JULY 21ExpirationStrike Price
Aug
Sep
Oct
221⁄2 calls25 calls30 calls
77338n/a
311,48269
285966
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209
Overall, this volume pattern was not “perfect,” but it was encouraging. Because of that, you might bring other factors in the decisionmaking. At the time, I felt that since the stock had topped out previously at 26 back in June, I would want to see it break out over thatlevel in July in order to confirm that the option volume pattern was ameaningful one.The next trading day, Monday, CHPM did indeed break outover the 26 resistance, and on a small gap to boot. Option volumeremained heavy, and the stock closed at 271⁄2. This was a clearsign to buy the stock. It traded as high as 313⁄4 over the next threedays, and option volume continued to be very heavy all during thattime. Surprisingly, the volume never did develop the “classic” pattern, as more September and October options traded than didAugusts.Nevertheless, a merger bid was received on July 27 from ThreeCom, and the stock jumped to 37. As an added bonus, after thatthere were rumors of a competing bid by Cabletron Systems; and thestock traded at 44 the next day! Although, the competing bid neverdeveloped, Chipcom rallied as the price of Three Com stock rallied.Again, a takeover situation was detected in advance by observers ofoption volume, although this time a little technical analysis had to bethrown in to complete the picture.There is one other trait of the Chipcom situation that is interesting—a trait that occurs with some frequency in takeover situations: the stock, while trending down, becomes a takeover targetbecause of its low stock price. It’s sort of a catch-22 situation. Thetarget company is doing poorly and its earnings are bad, so thestock sells off. However, if they have a good basic business, product, and so on the low stock price itself may raise the eyebrows ofcash-rich companies in its field. These cash-rich companies canthen step in and buy the relatively low-priced stock for what theyfeel is a reasonable price. In the case of Chipcom, the stock hadtraded as high as 51 in late 1994 (not shown on Figure 4.4),before plunging to a low of 20 in May 1995. This vast decrease instock price obviously attracted the attention of Three Com, whoapparently saw an opportunity to buy a (mismanaged?) company ata price well below its highs of the previous year. This theme of astock becoming a takeover target after its stock hits new lows is
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THE PREDICTIVE POWER OF OPTIONS
repeated in several of the upcoming examples, including the nextone—U.S. Shoe—to a certain extent.U.S. Shoe (USR) had traded up to a high of 24 in the summer of1994 before beginning an eight-month slide that took it to the18–19 area. While this wasn’t a large percentage drop, it was probably enough to help attract a buyer.The chart of USR’s stock price and option volume is in Figure4.5. The first high-volume day for option trading saw the stock riseto 201⁄2 (point A), as there were rumors that the company was goingto sell its footwear business. The very next day, the companyannounced that those talks had broken off, and the stock plunged to16 at one point before recovering a little to close at 171⁄4. Then, theday after that—February 21—the stock jumped two points to 191⁄4as takeover rumors surfaced. Table 4.4 shows the pattern of optionFigure 4.5U.S. SHOE
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Table 4.4USR: 191⁄4; FEB 21ExpirationStrike Price
March
April
July
Oct
171⁄2 calls20 calls221⁄2 calls
28565460
130603460
3110560
40
trading on that day, February 21, when 2,428 calls had traded, plus168 puts as well. Average volume was only 876 total contracts atthat time, so that day was nearly triple the normal option volume, awake-up call for option volume observers.Option volume continued to run heavy during the rest of February as the stock hovered near 19. It is somewhat ironic that volumetailed off on March 1 to 970 total contracts and to a very low 209contracts on March 2. The stock slumped to 183⁄4 as well, and itlooked like the rumors had cooled off. Then, the next day—March3—the company received a $25 per share takeover bid, and thestock jumped six points. The takeover bid had come from an outsidecompany, not the one that was originally discussing the sale of thefootwear division.Ordinarily, when you are trading based on increased optionvolume, we recommend that you take profits as soon as the newsbecomes public. You have established your position on the basisthat “someone” knows something about future corporate news. Ifyou are fortunate enough to have a position and then see that newsactually announced, you should say “thank you” and take your profit,as a general rule.However, as with all general rules, there can be exceptions, andU.S. Shoe was one of them. There is a postscript to the story of U.S.Shoe. Look at the graph in Figure 4.6. It is the same as the graph inFigure 4.5, except that the option volume is shown on through therest of the stock’s life. There was a huge surge in option volume onthe day the stock rose six points, which is certainly to be expected.However, option volume normally abates after that, especially if the
212
THE PREDICTIVE POWER OF OPTIONSFigure 4.6U.S. SHOE—OPTION VOLUME
takeover bid is a “done deal.” In the case of U.S. Shoe, though,option volume continued to be heavy (it technically wasn’t more thantwice normal because the heavy option volume on that one day hadinflated the average volume figures). Sure enough, the company thathad originally wanted the footwear division came back and bid ahigher price for U.S. Shoe. You can see from the graph that thestock was eventually taken over at 28 in May, a nice premium toeven the $25 offer of March.Option volume doesn’t just spot takeover situations. It is also veryuseful in catching corporate earnings surprises. It has been my experience that option trading activity will often pick up on the day beforea company releases its quarterly earnings. This is such a frequentoccurrence that option observers should probably not attempt totrade under those circumstances. However, if the option volume
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213
picks up several days before the earnings announcement—perhapsremaining heavy for several days prior—then there is a much betterchance that a meaningful trade is being predicted by the options.The next two examples are cases in point.Motorola (MOT) was due to release earnings on Tuesday, July12, 1994. Motorola’s options are generally quite active; but onWednesday, July 6, and for the next four trading days, the optionactivity picked up tremendously. Moreover, since the majority of thatactivity was in call options, it appeared that insiders had knowledgethat the quarterly earnings were going to be better than expected.Figure 4.7 shows Motorola’s stock price and option volume during that time. Notice that the stock had been trading in the 43– 48range during most of May and June 1994. During that time, optionvolume was fairly active, but normal. However, with the stock nearFigure 4.7MOTOROLA
214
THE PREDICTIVE POWER OF OPTIONS
the low end of the range during the first week of July, option volumebegan to surge (point A). The following data are from the first day ofincreased option volume—July 6—and are representative of the pattern that occurred during each of those four days prior to the actualrelease of earnings. Since a lot of puts traded that day, as well ascalls, Table 4.5 details the trading in all options. Just over 7,500 callstraded that day, and almost 5,400 puts traded as well. Average totalvolume at the time was 5,624 contracts, so the total volume on thatday (12,900 contracts) was over twice the average volume.The volume pattern in Table 4.5 is not as