Reading the Options Market Tea Leaves

by Jay Pestrichelli on January 24th, 2012

As we’re getting into the swing of earnings season, I thought it made sense to give a little insight as to how the options market is actually a tool to help the stock trader.

One of the things that most stock traders don’t know is that the money in the options market will give a hint as to where they believe the market will go. It doesn’t mean they’re right, it just means you can see the bias if you know where to look.

The first assumption is that those trading on earnings moves are speculators in nature. It’s safe to assume that they aren’t investing for the long haul if they’ve decided to buy the current month options if the day of earnings. So since they are speculators they are going to want to use the leverage power of options as much as possible. This means feeling the least pain with the most amount of gain. In other words, out-of-the-money calls or puts.

We like to look for the follow indications to tell what the options market is telling us. If we see buying calls above the market, we know they are speculating it will go up. If we see buying of puts below the market, we know they are speculating it will go down.

The strike prices at which they buy the calls or puts will also tell us how speculative they are. For example, buying the 600 strike puts on Google (GOOG) while it was trading at 630 the week before options would mean that you were planning on a significant drop. On 1/12 a 600 strike Feb put would have cost a trader ~$12. That means in order to break even by expiration the stock would have to get below $588 ($600 - $12) or at the least appear that it would get below.

If you were just going to use stock to bet Google was going to drop, you would have to short it and come up with $630 in buying power ahead of time. The point being, betting with $12 will risk a lot less than $630.

Fast forward one week, Google earning disappointed dropping the stock from $640 to $590 overnight and it closed that day at $585. Those 600 strike puts were now worth $22. Those holders made a $10 gain on $12. Obviously a better use of $12 than having to actually short the stock for $630 and making $45, so for investors that know how to do this, we call it the smart money. Not because they are right, it’s because they know how to use the leverage of options.

Wouldn’t it be great to know what the smart money was doing? Well you can. Its all right the option chain. You can tell when trader are adding puts and calls to the market with the open interest…and you know at what strikes their doing it.

But wait a minute; open interest will reflect long AND short positions. We know a short call is very different than a long call. So how can you tell if the market has a bias of adding long or short positions? The answer is to watch the implied volatility. As options are bought, like stock, their price goes up. There are a lot of things that go into option pricing, so just focus on the amount of money people are willing to pay for the probability to be right.

This is what the implied volatility figure tells us. If implied volatility is going up, then there are more buyers than sellers. The same applies for a dropping IV. It means that traders are selling options.

With these two data points of a rising/falling open interest and a rising/falling Implied Volatility, you can determine what is going as a specific strike. You can tell if they are adding new long or short positions or tell if they are closing existing positions. You can usually find the IV in the options chain as well and hopefully you’re using a platform that lets you look back on historical to track the changes.

You can use this table to keep all this straight:
Try this out this week. Take a look at Apple (AAPL) options today and see if you could accurately read the tea leaves before tonight's earnings.


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