5 Ways Stock Traders Can Use Options Action to Gauge Stock Trends

If you actively trade stocks and you don’t pay attention to news from the world of equity options, listen up. Here are five ways to profit from options action:

1) Big Volume: When institutional traders want to build a bigger position in a stock without moving the market, they often use options to do it. Since every options contract represents 100 shares of underlying stock, a purchase of 5,000 calls or puts is pretty meaningful and something you should pay attention to if you have, or are considering, a trade in that stock.

Every morning in the SideWinder Update, we report on sizable volume trades in equity options. The broker OptionsHouse also has a “Hot List” of high volume option trades. And daily articles from Jud Pyle in his Volatility Overlays column always seem to find what the big and/or “smart” money is doing in options.

2) Implied Volatility: Options prices are determined by expectations about future volatility and thus risk. The prices of options imply a certain expected volatility. When option prices move higher without the underlying stock volatility increasing, this is a bet by option traders that future volatility/risk will be higher.

For instance, in September before Research in Motion (RIMM) reported earnings, the implied volatility of its options had been sharply on the rise for over a month. This was not surprising to options traders who have seen volatile moves in RIMM shares following its earnings report. This higher expected volatility was driven by both put buyers seeking protection and call buyers looking for a breakout in the stock. As it turned out, the bears were right, and anyone who bought put protection, and sold calls to finance them, did very well.

3) The Straddle: Options traders are obsessed with volatility of all kinds. But one simple measure of vol is the at-the-money (ATM) straddle. When the combined prices of the put and call both go up from the day before, more risk and uncertainty is getting priced into the stock. For instance, if a stock is trading at $25.49, the ATM straddle is the price of the 25 call and 25 put added together.

Every day, options lose a little of their value as time passes.  But if the straddle price is rising, options volatility is on the move higher. Stock traders have to decide themselves if this increased expectation for volatility aligns with their bullish or bearish views, but it is useful info nonetheless. The SideWinder Update points out straddle moves every day.

4) Premium Sellers: Many option traders, from institutions to one-man operations, make their livings from selling option premium. When stocks trade in ranges, the premium sellers try to sell upside calls at the top of the range and downside puts at the bottom. This doesn’t create the trading, but it’s worth noting that lots of sober opinions are getting expressed.

In other words, these are the folks who don’t think XYZ is going to the moon, or the basement. They just play the range by selling iron condors and other credit spread strategies. Another element of this that supports the trading range is that when someone sells a call to an options market maker, that market maker must sell the stock to hedge. And vice versa with puts—when the market maker buys puts from the put sellers, he or she then buys stock to hedge.

5) ETF Options: The expanding universe of ETFs offers stock traders new vehicles for expressing their views across multiple asset classes with lower cost and risk. Institutions use ETFs and their options for sector rotation and efficient asset allocation on a daily basis because options provide leverage and versatility they can’t get anywhere else.

The daily volume in an ETF may not give you an idea about “big money” moves in or out of a given sector, but the options action will. Stock traders should make it part of their weekly routine to watch for big volume in sector ETFs for ideas about broad-market trends. Don’t miss my articles of the past two days on “Big Options Action in ETFs.”