clear-cut as one mightlike to see; but since the options were so active, it is worth analyzing.First, you must remember that Motorola options are always active toa certain extent. So, whatever normally causes that activity was probably taking place on July 6 in the normal course of events; then, ontop of that activity, there was some speculative activity as well, inadvance of the earnings report. If you only look at the striking pricesof 45 and higher, the pattern looks fairly speculative in terms of callvolume. There are a number of puts trading at those strikes, butnothing unusual compared to the calls. So, from observing the activity at the three higher strikes, you would figure that the option volTable 4.5MOT: 441⁄2; JULY 6ExpirationStrike Price
July
Aug
Oct
Jan
40 callsputs
1,980998
52167
301,451
5042
421⁄2 callsputs
1221,113
0
1946
45 callsputs
1,152399
746220
103125
471⁄2 callsputs
1,363322
504
244125
50 callsputs
8040
299290
12231
2249
USING STOCK OPTION VOLUME AS AN INDICATOR
215
ume was predicting a positive earnings surprise because of the heavycall volume.However, at the two lower strikes, things get a little cloudy.There are a lot of puts traded at those strikes, and you might thinkthat those puts were predicting bad earnings on the horizon. TheJuly 421⁄2 puts, which traded 1,113 contracts, certainly look likespeculative volume. However, the Oct 40 puts, which traded 1,451contracts, probably are not speculative because speculators would bebuying July or August puts. Finally, the July 40 puts (998 contractstraded) might easily be part of an arbitrage with the July 40 calls,since so many of those calls traded, too.Sometimes, when both call volume and put volume are heavy,the stock can be ready to make a rather large move in either direction. It can be very difficult to determine that direction merely fromobserving the option volume, because of the balance in call volumeand put volume. This phenomenon can arise, in part, because market makers are trading puts to hedge calls, or vice versa, thereby distorting the option volume patterns created by the speculators.Motorola calls were quite expensive, since the speculators were buying them heavily. So, market makers, who were short calls by virtueof their market-making activity, might have sold stock and boughtsome of the puts to hedge their short call position.In Motorola data just discussed, it appears that the call volumehas a more speculative look than the put volume because of the factsmentioned regarding the Oct 40 puts and the July 40 puts. However, rather than attempt to get too deep into analyzing why therewas heavy option volume in specific series, I prefer to watch thestock price for a minor breakout in either direction in order to confirm the direction of the move. On July 6, the day in question, MOThad had a high of 441⁄2 and closed at 44. The stock traded higherover the next two days, which to me was a confirmation that thepending move was going to be to the upside.This volume pattern continued pretty much the same way for theensuing three days. Total volume was more than double normal volume; and, while call volume was dominant, there was a lot of put volume trading as well. Finally, on July 12, the earnings were releasedand were a huge positive surprise. The stock gapped higher on theopening and closed over five points higher that day.
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THE PREDICTIVE POWER OF OPTIONS
All in all, this example shows several typical things. First, if youare going to use option volume to predict an earnings surprise, youwant to see the option volume reach high levels for several days priorto the actual earnings announcement itself. Second, when optionactivity increases in a stock where options are normally quite active,then you are going to have extraneous volume clouding the issue, soyou must be a little more analytical in interpreting what the optionvolume is predicting. Third, whenever puts and calls are both active,you can use the stock price itself as a guide to the direction of theeventual move.Another classic example of how option volume predicted anearnings surprise occurred in the spring of 1995 in Sybase (SYBS).This one, however, came on the downside and was predicted byheavy trading in Sybase puts for a significant period of time.The graph of Sybase and the total option volume are shown inFigure 4.8. The stock had been under a little pressure in the fall of1994 and then made a disappointing earnings announcement inJanuary 1995. The stock fell over six points on that day, and optionvolume surged (point A on the graph). That volume, however, wasnot predictive—it was reactive, as it came after the news wasreleased.SYBS continued to trade sideways at a lower level—42 to 46—until late February, when rumors began to circulate that the earningswere going to be bad again at the next earnings release. This causedanother spike in option volume (point B), much of which was put volume. However, after a brief foray below 40 on the last trading day ofFebruary 1995, the stock climbed back into the trading range.On March 21, option volume surged again (point C), and it hadthe same pattern of heavier put volume than call volume. That camewith the stock at 441⁄4. From that time on, the stock basically tradeddown. Since that day—March 21—was the best day to buy puts, thatis the day whose detailed trading is shown in Table 4.6. A total of3,670 contracts traded that day, and 2,450 of them were puts, anunusually large percentage (67 percent). Note the volume in the deeplyin-the-money puts, a very bearish sign. Average volume at the timewas 1,256, so the 3,670 contracts was almost three times normal—enough to bring this situation to the attention of option observers.
USING STOCK OPTION VOLUME AS AN INDICATORFigure 4.8SYBASE
Table 4.6SYBS: 441⁄4; MARCH 21ExpirationStrike Price
March
April
40 callsputs
1500
0280
45 callsputs
180420
270450
50 callsputs
00
6201,100
55 callsputs
0100
June
0100
217
218
THE PREDICTIVE POWER OF OPTIONSTable 4.7SYBS: 381⁄ 2; APRIL 3ExpirationStrike Price
April
May
June
35 callsputs
0960
0750
0110
40 callsputs
890940
220630
150
45 callsputs
410200
78
50 callsputs
0280
180
55 callsputs
0100
From that day on, Sybase traded lower, eventually breakingbelow 40 on April 3. There was heavy option volume on both Friday, March 31, and Monday, April 3 (point D in Figure 4.8). OnMarch 31, 3,638 contracts traded, of which 1,830 (or 50 percent)were puts. That wasn’t quite as impressive as the option volumeshown in Table 4.6, but the trading on April 3 left little doubt as towhat the option volume was attempting to say (see Table 4.7).Option volume jumped to nearly 5,800 contracts on this day, andputs accounted for a staggering 4,120 contracts (71 percent of totalvolume). Look at the huge volume in the out-of-the-money puts witha striking price of 35. This was a sign that the bearish speculatorswere out in force and with confidence.The next day, April 4, the company made a preearningsannouncement, indicating that earnings (which were not to bereleased until later in April) would fall short of expectations. Thestock opened 14 points lower. A masterful coup for observers ofoption volume.The next example is one that is less clear-cut than some of thosepreviously shown. It involves Syntex (SYN), which was a long-
USING STOCK OPTION VOLUME AS AN INDICATOR
219
rumored takeover stock. Unfortunately for most of the people whohad bought Syntex over the years, the takeover never actually materialized; and, in fact, the stock kept drifting down to lower and lowerlevels. As was mentioned earlier, if a company has a viable business,a low stock price may attract suitors. This fact is not lost on the WallStreet crowd, however, so the least little hint of a rumor was all itwould take to get Syntex stock and options excited. We discuss thisexample in some detail in order to show you that things don’t alwayswork out as planned.The graph of Syntex and its option volume is shown in Figure4.9. The time frame is late 1993 and the first third of 1994. Syntexstock had been as high as 54 in the past (1991) but by late 1993 wastrending down toward 15. In mid-December 1993, option volumesurged a little and the stock made a bottom, rallying to 17 by yearend. The big volume came on the first trading day of 1994, howeverFigure 4.9SYNTEX
220
THE PREDICTIVE POWER OF OPTIONSTable 4.8SYN: 167⁄8; JANUARY 4ExpirationStrike Price
Jan
Feb
March
June
15 calls171⁄2 calls20 calls
3502,924302
544529
2149931,229
18583579
(point A on the graph). On that day, January 4, the option tradingvolume was as shown in Table 4.8.Call option volume surged to 7,931 contracts that day, and 479scattered puts traded as well. Since average volume was only 2,377 atthe time, this was indeed a significant surge of option trading. Moreover, it had a very speculative look, although it might have beenpreferable if more trading had occurred in the January and Februaryseries and a little less in the March series.As good as the option volume looked on January 4, it proved tobe a one-day wonder and—worse yet—it marked an intermediateterm top for the stock, exactly the opposite of what is “supposed” tohappen. Instead, the stock fell to 14 by early February, and optionvolume died down substantially.The stock stabilized in mid-to-late February, and option volumebegan to surge once again. This time, however, traders were morereluctant to chase the stock; and it didn’t advance much until lateFebruary, when option volume surged so much that it went clear offthe top of the graph in Figure 4.9 (point B). Somewhat ironically, thestock only rose by 5⁄8 to 145⁄8, again demonstrating the skepticismwith which stock traders viewed Syntex. However, those with insideinformation were becoming even more aggressive in buying the calls.Table 4.9 shows how the option volume looked on that day of heaviest volume, February 25. Call volume was a massive 12,851 contracts, and an additional 6,500 puts traded as well. At the time,average daily volume was 3,383, so once again this was an opportunity for followers of option volume to buy the stock.
USING STOCK OPTION VOLUME AS AN INDICATOR
221
Table 4.9SYN: 145⁄8; FEBRUARY 25ExpirationStrike Price
March
April
June
Sep
121⁄2 calls15 calls171⁄2 calls20 calls221⁄2 calls
5148,0811,16817230
331,154177
2653,9642,744535414
188379253
Option volume remained very heavy for the rest of February andthe first half of March (see Figure 4.9). Unfortunately, the stock didnot make much headway. It did trade up to nearly 16, but that was inearly March. Then, once again, it began another rather nasty descent,eventually falling to 121⁄2 in mid-April. With the decline in the stockprice, option volume had almost completely dried up by mid-April. Atthat time, however, option volume once again returned (point C inFigure 4.9). As had happened in February, the stock price did notreally trade higher—again showing the skepticism amongst traders.Then, in late April (April 23), both the stock and the options got“heated” together. First, the stock jumped from 12 to 13 in one day,and simultaneously option volume rose to the highest levels sinceMarch. Then on April 29, Syntex traded over 15, and option volumeonce again had an extremely speculative look (see Table 4.10).Table 4.10SYN: 151⁄8; APRIL 29ExpirationStrike Price
May
June
Sep
Dec
121⁄2 calls15 calls171⁄2 calls20 calls
562,45343624
853,9223,596741
71693370164
3432
222
THE PREDICTIVE POWER OF OPTIONS
Nearly 13,000 calls had traded; and even though over 3,000 putstraded (most of them with a strike of 10), this was a sign that therumors were back in force.Those traders who weren’t gun-shy from having traded Syntexbefore were able to buy it and reap the rewards—which were huge inpercentage terms—as the stock received a takeover bid and openedat 231⁄2 the next day. In the minds of many traders, Syntex was a“good riddance” type of stock. This was true for short-term traders,who had been “burned” by many false takeover rumors in the past, aswell as for long-term holders, who saw the stock taken over at a pricethat was less than 90 percent of the daily closes over the previousseveral years. Only the observers of option volume felt somewhatredeemed, and even they had lost money a couple of times beforethe final takeover occurred.This example not only shows that surges in option volume arenot guarantees that a takeover or earnings surprise will happen everytime, but it also stresses the need for money management. Sincethese are short-term trading situations, I strongly recommend thatyou use a tight stop on any purchase made using option volume asthe catalyst for establishing the position. In my mind, that means taking a loss of no greater than one point on any position (unless, ofcourse, the stock gaps open). Thus, if you had bought the stock inearly January at 167⁄8, you would have been stopped out within twodays. Then, in late February, you would once again have beenstopped out in late March or early April (although most short-termtraders wouldn’t hold a stock for a month if it wasn’t going higher).Even though these were both losing trades, losses would have beensmall. That is an important fact, for you need to have your capitalfairly intact because the next opportunity—in late April—was the realthing. So, if you had limited your losses on the first two trades, youwould have wound up with a nice overall profit on the third trade,which resulted in a big gain.As an end to these examples, it should be pointed out that notevery major corporate news event is leaked beforehand. It is fairlycommon to see a takeover occur that had little or no advance notice.Mostly these unknown takeovers are in smaller stocks, but occasionally they occur in very large stocks as well. One large takeover that
USING STOCK OPTION VOLUME AS AN INDICATOR
223
was kept quiet was Matsushita’s takeover of MCA/United Artists inthe early 1990s. MCA was in the midst of a very nasty decline inconnection with the bear market of that year; it traded down to 34,from a high of 71 earlier in the year. Suddenly, and without warning,Matsushita made a bid for $71 for the company, and it gapped up to$60 the next day.In a similar manner, one of the biggest mergers of all time, interms of dollar amount of stock purchased, was kept quiet; and it wasnever rumored—even by analysts—because the combination didn’tseem possible. That was Disney’s takeover of Cap Cities ABC in thesummer of 1995. Cap Cities had been trading quietly at 96 on aslow Friday in July. The total option volume in Cap Cities that daywas 100 contracts, as compared to an average volume of 272—nothing unusual at all there. Moreover, Cap Cities had been in adowntrend with low stock volume. Disney made an astounding bid of$65 per share plus one share of Disney. Since Disney was trading atabout 65 at the time, this equated to a $130 bid for Cap Cities.This just goes to show that a takeover can be kept quiet, but itusually isn’t if too many people know about it. In the Disney situation, the deal was originally proposed personally by the chairman ofDisney to the chairman of Cap Cities. Then they brought in a fewtrusted confidantes to hammer out the details. However, as soon asyou start involving investment bankers, printers, and the like, thechances of someone “spilling the beans” increases greatly. Once theinformation is in the hands of disinterested parties, those parties areprobably going to buy options; and that’s where we can profit.
ProfitabilityThe preceding examples are certainly enough to demonstrate theworth of trading stocks based on increasing option volume. Largeprofits are possible; and if you limit your losses with fairly tight (mental) stops, you can expect to achieve an excellent rate of return. Inorder to help you gauge what to expect, some general statistics canbe offered.First, no matter how careful you are with your screening ofoption activity, you are probably going to have losers on slightly
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THE PREDICTIVE POWER OF OPTIONS
more than 50 percent of your trades. Some of these are caused bypicking up stock in which the option volume was due to extraneousfactors rather than being caused by those with inside information.Second, with the use of tight stops, you may find that a stock backsoff and stops you out, due to a large seller—who sells because ofprice considerations, having nothing to do with corporate news— ordue to a cooling of somewhat widespread rumors. You may findyourself reentering these stocks (à la the Syntex example given earlier) if the rumors return. Personally, I prefer to take the small lossesand then reenter the position if it becomes active again.As for taking profits, or at least protecting them, there are atleast three considerations. First, as mentioned before, you can liquidate your position when the corporate news becomes public. Generally, this is a most pleasing task, for the announcement will makethe stock move in your favor. Sometimes, however, the corporateannouncement means taking a loss, and these losses can be some ofthe largest and most painful. For example, I have seen situationswhere call trading volume built up heavily for several days prior to astock’s earnings release. Then, the actual earnings, when announced, were only in-line; or perhaps the earnings were good butprojections for the next quarter’s sales didn’t look so good; or something similarly negative was stated by the company along with theearnings release. In a sensitive market, such a stock can gap down,perhaps opening below your stop price, thereby causing a loss.Second, you can use a trailing stop. If the stock begins to move inyour favor, but no actual corporate announcement is forthcoming,then I would suggest that you raise your stop price. As these unrealized profits begin to accrue, you may want to give the stock a littlemore breathing room by setting the (mental) stop price somewhatmore than a point below the stock’s price. You would approach theprofits in this manner because the objective of (short-term) trading isto let profits run.In fact, I use a trailing stop as a mental closing stop in nearly allof my trading. You can use something simple, such as the 20-day simple moving average; or you can use more advanced stops— ones that“hug” the stock price more closely in the case of a strong, even parabolic move in your favor—such as a chandelier stop or a parabolicstop. The old Wall Street adage, promoted by the media, is that it’s
USING STOCK OPTION VOLUME AS AN INDICATOR
225
hard to cut your losses and let your profits run. But it really isn’t. If youset a reasonable stop to begin with and have the discipline to adhereto it, you will cut your losses. In addition, if you use a trailing stop,you will let your profits run. In this way, you can be a smart trader.Note: by using a mental closing stop, you don’t actually place astop order on the trading floor. Rather, you check the market nearthe close of trading and, if the stock is below the stop price (whenyou’re long), then sell out your stock or your long calls. If you arebusy and don’t get a chance to look at the stock price before themarket closes, then sell out your position the next morning if theclosing stop was violated. Finally, notice that these stops are basedon the closing stock price, not the option price. I think this is themost efficient way to operate, as stop orders on options can be difficult. These concepts are expanded in the later section in this chapter: Using Stops.Third, I would recommend taking partial profits if you get a substantial, quick move in your favor and no corporate news has beenannounced. This tactic allows you more freedom to hold the remainder of your position with a slightly wider stop. It also ensures thatan unforeseen news development won’t be as painful as it mighthave been.A classic example of the usefulness of money management occurred in thetrading of U.S. Surgical in July 1995. The stock had, at times in the past,been the subject of takeover rumors, and heavy option volume occasionallydeveloped. This time, the stock was trading at about 241⁄2 when the optionvolume shot up, and option observers bought the stock in that price range.Two days later, better-than-expected earnings were reported, and a majorbrokerage firm upgraded the stock on projected improved earnings. Thestock traded above 27 in just three days. At the time, we recommended toour clients that they take partial profits and raise the stop to 251⁄2 from itsinitial level of 233⁄8.The very next day, after opening near 27, the same analyst recantedhis positive expectations. It doesn’t really even matter what his reasoningwas (although it certainly seemed specious), but the stock proceeded to fallover two points that day, stopping us out of the position. Fortunately, withthe use of the trailing stop and the fact that we took a partial profit, we stillhad nearly a two-point gain in a very short period of time.
226
THE PREDICTIVE POWER OF OPTIONS
This tactic of taking some partial profits can even be applied tointraday trading, as sometimes you will already be in a position whenrumors come into the market and make the stock go to extreme levels. At extremes, natural sellers may appear, based merely on price(or buyers, if you are short). For example, Integrated Silicon stock wasmentioned in an earlier example as having had heavy put volume. Wehad our customers short the stock, and it proceeded to fall sevenpoints in three days. Then on the third day, it was down another sixpoints before rallying nearly four points near the close. Natural buyershad appeared; they figured the stock had gotten so cheap that it wasa buy regardless of what kind of bad news was coming out. The nextday, the stock rallied five points. Those traders able to watch the stockin real time were able to react when they saw it reverse direction asbuyers stepped in. Covering at that time was superior to waiting untilthe closing or until a buy stop was later elected.
Further ConsiderationsYou can readily see that this analysis of option volume requires youto have access to “average option volume.” We use the 20-daymoving average of volume in our calculations. We also keep the 20day moving average of both puts and calls separately. There arevery few software systems that provide this information; and noneof them do the screening that is necessary, for that is largely ahuman function. One software vendor that provides this information is Option Vue; and through their Opscan service, you can customize your analysis significantly, but you may still be left with alarge number of choices. On an average day, there will be 40 ormore stocks whose option volume is more than double its averagevolume. However, after screening, only a handful are actually showing speculative option buying—the others are distorted by coveredwrites, spreads, and arbitrage. This means that the best, and only,way to accurately screen the volume is for a trader who understandswhat he is looking for to analyze the data. With practice, this canbe you, if you have access to the data. Another way is through ourDaily Volume Alert service, where we do the screening and report
USING STOCK OPTION VOLUME AS AN INDICATOR
227
the few situations that represent true speculative volume each day toour subscribers.I am often asked the question, “Do you personally buy the stockor buy the options, and, if options, which ones?” A lot of the time,the options in these rumor stocks are quite expensive because notonly are the insiders buying them, but other traders and market makers are buying them as well. This makes the at-the-money and out-ofthe-money options too expensive to buy in most cases. I typicallyprefer buying the short-term, in-the-money option because it haslittle or no time value premium and therefore behaves very much likethe stock does.While an in-the-money option doesn’t have the extreme leverage capability of an out-of-the-money option, it still provides leverage; and it will generally make a profit whenever the stock makes amove in your favor, no matter how long it takes or how small themove, which cannot be said for owning out-of-the-money options.There is nothing worse than owning an expensive option out-of-themoney if a rumor that is supporting the stock is denied by the company. The stock drops, but the options absolutely collapse asimplied volatility drops. Thus, you can have situations where the atthe-money option drops in price nearly as much as or more than theunderlying stock does.Even though I prefer using the in-the-money option, I wouldnever argue with someone who wanted to purchase the stockitself. In a trading situation, it is often better to be in the stock thanin options. Stock is more liquid, the bid–asked spread is often tighter,and you can use stop orders if you want to. I do not recommendusing stop orders with options—you will invariably be disappointedwith the results over the long term. Also, you will find that in a trading situation you will be taking small profits fairly often, perhapswhen the stock moves a point or two in your favor. Options, ofcourse, will move in your favor when the stock does, but the liquidityof the stock often makes it a better trading vehicle.Is there ever any purpose in using out-of-the-money options inthese speculative situations? Yes, there is. When the options areexpensive, then I often use a bull spread, even an out-of-the-moneybull spread.
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THE PREDICTIVE POWER OF OPTIONS
With Federal Paperboard (FBO) at about 41 in early November 1995,option volume was very strong, so that a purchase was in order. However,the options were extremely expensive:FBO: 41Nov 40 call: 4Nov 45 call: 2Nov 50 call: 1These options had only a couple of weeks of life remaining, so you cansee how heavy the speculation was. I recommended that our customers purchase the Nov 45–Nov 50 call bull spread. This cost 1 point, or perhaps11⁄4, the next day.Within a week, the stock was taken over, and it traded at 53. The spreadwas removed for 47⁄8. This is a classic case of why a bull spread is sometimes useful.For comparison purposes, let’s say the spread was sold for 5, and anyof the other options could have been sold at parity with the stock at 53. Thefollowing table compares the various returns that would have been availablefrom various purchases:Purchase
Cost
Sale Price
Return (%)
Bull SpreadNov 40 callNov 45 callNov 50 callCommon stock
142141
5138353
40022530020029
Thus, the spread was the best choice by far, in terms of returns realized.The reason that it was able to outperform the other calls was that each individual call was so expensive to begin with that it hampered the overallreturns. However, at least in the bull spread situation, we were both buyingand selling an expensive option; and that balanced itself out somewhat. Ofcourse, had the takeover been at a much higher price, the spread would nothave been the best winner; but it would still have done very well, and its initial cost was small— only one point.
USING STOCK OPTION VOLUME AS AN INDICATOR
229
Using StopsIt was mentioned earlier that you should use protective stops, andfairly close ones at that, when operating a short-term trading strategy. This concept pertains not only to stock trading (whether basedon option volume or any other criteria), but to futures trading as well.With the use of stops (and letting your profits run), you can operatevery profitably even if you only have 40 percent to 50 percent winners. You should also favor the use of trailing stops—adjusting yourstops to lock in profits if you are fortunate enough to have the stockmake a move in your favor. You don’t necessarily have to keep thetrailing stops as tight as the initial stop; you may want to leave thestock a little more room if it is already moving in your favor.A concept that I usually recommend if you have access to realtime data or if someone is watching your account for you is to usemental stops instead of actual stops. An actual stop is a stop orderthat is actually placed with your broker and is therefore an order onthe floor of the exchange. The advantage of the actual stop is thatyou don’t have to monitor it—it’s always working for you even whenyou’re away doing something else. The disadvantage of the actualstop is that you don’t get a chance to assess the situation when thestock gets to your stop price; you are automatically out. Moreover,you might not get a particularly good execution; and even thoughthis sounds a little paranoid, it does happen; sometimes the specialists or market makers will drive the stock down only to “pick off”your stop and then the stock will go right back up again.The mental stop allows you some flexibility when the stock hitsyour stop price. The way a mental stop is normally implemented is toset a limit minder on your quote machine at the price in question.Then, when the stock hits that price, your quote machine will “beep”or otherwise signal you that a limit has been reached. You can thenlook at the stock and perhaps watch its trading activity for a few minutes to see if this is actually a time to sell the stock. For example, ifthe stock hits your mental stop price, but you see that there is a largebid for the stock and that the selling has been rather light, you maydecide that this would not be a good time to sell the stock, and youwould continue to hold it. On the other hand, if you see that the sell-
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THE PREDICTIVE POWER OF OPTIONS
ing has been aggressive and that bids are