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3 Reading Order Flow For Unusual Options Activity What are Options and Why Is Reading Order Flow Important? An option is a contract between the buyer and the seller. There are two types of options: calls and puts. Calls give the buyer the right, but not the obligation, to buy a specified stock or financial instrument (the underlying ) at a specified price (the strike price ) on or before a specific date ( expiration ). The buyer has the right to buy the underlying at the strike price, and the seller has the obligation, but not the right, to sell the underlying should these conditions be met. Puts give the buyer the right, but not the obligation, to sell the underlying at the strike price on or before expiration. Put buyers have the right, but not the obligation, to sell the underlying stock (or other instrument) at the strike price on or prior to expiration. Alternatively, put sellers are obligated to buy the underlying at the strike price should a buyer choose to exercise these rights. So what factors determine how these options are priced? Six factors, or price inputs, determine an option premium : the stock price, the strike price of the options, the time remaining until expiration, dividends, interest rates, and implied volatility. In general, the more a given stock fluctuates in price on a daily or weekly basis, the more expensive its options will be, and vice versa. Options usually tend to be more expensive prior to earnings reports and other major announcements but decrease in price sharply after the announcement, once the uncertainty has been removed. A good example of this is biotech stocks and drug announcements. Options are traded for one of two reasons: as speculation or to hedge against a stock position. Options are bought as speculation a stock will move in a certain direction. Calls may be purchased because a trader believes the stock will move higher prior to expiration. Alternatively, puts may be purchased because a trader believes the stock will move lower prior to expiration. The terms in-the-money, at-the-money, and out-of-the-money are used to describe the relationship of an option s strike price to the price of the underlying stock. A call is in-themoney when the stock price is above the strike price. Alternatively, a call is out-of-themoney when the strike price is below the strike price. As you might guess, if a call is at-themoney, its strike price is equal to the stock price.

4 The inverse is true when looking at puts: if the strike price is above the strike price, a put is considered to be in-the-money. A put is out-of-the-money if the strike price is below the stock price, while the at-the-money definition is the same as for calls. Options are also purchased to hedge against stock positions. Each day, I watch over 2,000 trades in real-time as they hit the tape. I always try to determine, are these orders a hedge against a stock position, or a speculative play? In the eleven years I spent trading on the floor, I learned how to Read the Tape. Most certainly a combination art and science, it is a skill I ve honed over the years. A large part of my trading strategy is based on my ability to do this. By watching for big block option orders, dubbed unusual options activity, I try to determine the positions of Paper. Paper is term originating from the trading floor, when order were actually written on paper and run to traders in the pit by clerks. It is used to describe large institutions such as hedge funds, mutual funds, or large banks. In other words, institutions who have access to better information even insider information than your average trader or investor. When trading off of unusual option activity, I only want to take trades based on orders I believe to be speculative plays. Given the sensitive, and even illegal, natures of their positions, hedge funds tend to be a secretive bunch. Thus determining if these trades are speculative or a hedge is like piecing together a puzzle. Let s put it another way: what if you could have taken the same trades as Raj Rajatnam, or SAC Capital s Steve Cohen, the moment they were put on? But I d go to jail for insider trading, you might say? Not so fast.. The moment an order hits the tape, it becomes public information. I can trade off it, based on the fact that I believe someone placing such a large bet has access to insider information, and it is completely, 100% legal. This isn t a matter of debate, or speculation, ask any SEC lawyer you know. This is why I trade unusual options activity. And this is why it works. (Want to watch professionals trade UOA in real time? Watch real time, real capital trades all day long in our trading room! Click here to try the room!) The Unusual Options Activity Trading Plan There is no secret to becoming a profitable trader and you should be skeptical of anyone who tells you otherwise. That being aid, the techniques I ve outlined in this text served me very well in my trading career and without them I would not have made the money I did. Reading order flow and watching unusual options activity continues to be one of my most profitable techniques, just like it was on the trading floor. I had two very profitable years in Apple stock when my net profits in AAPL were over a million dollars. Once a week for a

5 year, a Merrill Lynch broker would walk into the pit and sell AAPL put spreads. His acronym was HES, and whenever I would see him coming I would know to get long and sell volatility. How did he know? No clue, but by watching him I made quite a few profitable trades. By combining order flow with technical indicators like the Ichimoku cloud, I devised my OCRRBTT trading plan to trade profitably off of the floor. The OCRRBTT Trading Plan Pronounced Oak Ribbit, this trading plan will give you a step-by-step method for breaking down unusual option activity. After evaluating unusual trades with this plan you will be able to decide if you want to follow it or ignore the trade altogether. The letters in the acronym stand for open interest, chart, risk, reward, breakeven, time, and target. Here you will see the importance of each of these elements in the plan. Open interest: The first thing you need to look at is if the trade volume is bigger than the current open interest in that line. If it is this means that this is an opening position and is worth taking a look at. You don t want to buy an option on unusual activity if it is really just paper covering a short. Only consider trades where volume is greater than open interest. Chart: This is the second most important element of the plan. Once an unusual order is confirmed to be an opening order you must then look at the chart of the underlying stock. You need to ask questions. Is the stock in a strong bullish or bearish trend? Is there support or resistance at the strikes the institution is trading? Is it more likely they are speculating on more upside or downside or could they be hedging? The answers to these questions will help you determine if the trade is speculation or a hedge. This will keep you from trading against the institution when you actually want to trade with them. Risk, Reward, and Breakeven: Once the direction of the trade is determined you have to evaluate if the risk vs. reward profile of the trade the institution executed is in line with your risk tolerances. Some trades they take could be far too risky for the average retail trader. However, since you know the direction the institution is betting you can tailor a trade that has the right risk setup for you. The risk of each trade must also be measured against the potential reward. If the institution is risking $5 to make $1 this is a trade you would want to avoid. You should also always be aware of the breakeven of each trade. If there is significant support or resistance at the breakeven point you may want to consider another strategy. Time and target: Always be aware of potential catalyst events that might be near. You want to know if paper is playing the overall direction of the stock or if they are playing a near term catalyst event like earnings, drug announcements, or new product launches. This might factor

6 into your decision to take the trade or not. Once you have your time horizon set you want to pick a profit target. Are you leaving this trade on to expiration? Taking off half at a double and letting the rest ride? Knowing the answers to these questions on the onset of the trade make it easier to manage going forward. Putting the Plan to Work Once a trade hits the tap a trader must use the OCRRBTT trading plan to analyze the setup and determine if it represents an actionable trading opportunity. Let s look at the example below and determine if it is a trade setup that we actually want to take. This order hit the tape on June 16 th Before running this trade through the plan we need to understand the information we have. We are able to get a lot of information from orderflow. We can see how many contracts this trader bought, that it was a $540,000 bet and that the trader that bought these options paid through the market makers offer to get filled. Although all of these things make this trade interesting they still do not necessarily qualify it as an actionable setup. To make this determination we must evaluate this trade using the OCRRBTT Trading plan.

7 Open Interest: Was this an opening position? This trade is labeled opening so there is no doubt it was an opening position. If for some reason the trade was not labeled opening we would still be able to confirm that it is because the volume of 5,000 contracts is greater than the current open interest in the line of only 796 contracts. With open interest smaller than volume there are not enough open contracts in the lne for this to be a closing trade. It is confirmed opening. Chart: Does the chart indicate this trade is more likely to be a hedge or a speculative bet? We need to conform that the underlying trend of the stock supports this as a speculative bet. If it does not the trade may be a hedge and it is less likely to be actionable. To do this we will use an indicator called the Ichimoku Cloud. It may look intimidating but for this purpose a trader only needs to know that anything trading above the shaded area on the chart is in firm bullish territory and anything below it is in bearish territory. Here is the chart of CAG on the Ichimoku Cloud the day these calls hit the tape: We can see that the stock is trading above the Ichimoku Cloud and is an established bullish trend. This does not confirm with 100% certainty that this order was indeed a speculative bet but it makes it far more likely that this is the case. With the trend supporting the idea of this trade as a speculative bet we will move on to the next part of the analysis. Risk and Reward: Does the potential reward justify the risk? This is a very large trade in what is generally a boring stock. ConAgra (CAG) doesn t usually get much unusual activity so if the risk and reward setup makes sense it might want to be a trade that we want to take. This is an outright call buy and a trader knows that they can never lose more than $1.08 in

8 this trade. This translates to $108 in risk per one lot with what is a technically unlimited upside reward potential. This sets up for a good reward to risk setup and a trader can take this trade. Breakeven: Where is the breakeven point in this setup? These options are just out of the money and are being bought for $1.08. At that strike price that would make this traders upside breakeven $40.08, or about 4.6% higher than the stock s price at the time of the trade. This is only a 4.6% move to the upside. That is not an unreasonable move. With that in mind the setup becomes even more attractive. Time and Target: What is the trader expecting? In this trade they are looking for a move to the upside of at least 4.6% by July expiration. Since the trader bought he Jul 39 calls we will buy the same ones. A trader should never trade a different expiration or price target than the institutional trader. Remember, they have better information than us. Everything about this trade sets up well. All of the evaluations in the OCRRBTT trading plan point to this being an actionable trade setup. The Result This trade ended up being a fantastic winner. The trader s motivations behind this trade become much more clear 3 days later when news breaks of activist activity in CAG.

9 Look at how the stock responded to the news: The stock gapped to the upside and these options exploded in value. Anyone looking at the reaction in the stock might be surprised by the huge move to the upside but for those paying attention to unusual options activity were alerted to this potential move 3 days before it actually happened. The options that the institutional trader bought saw an enormous move to the upside trading as high as $6.20 before expiration. This means that at the highs this trader would have profited $2.56 million dollars at the highs. Look at a chart of the options below.

10 A retail trader who followed this trader with a 20 lot of these options would have profited $10,240 at the highs. This is a perfect example of how a retail trader can harness the power of institutional order flow and trade more like the biggest and most successful hedge fund managers in the world. (Want to trade setups like this as they happen? Watch real time, real capital trades all day long in our trading room! Click here to try the room!) Another Example of Profitable UOA While the OCRRBTT Trading Plan gives a trader a methodical and systematic way to analyze unusual options activity the context of a trade can often play an important role in determining whether or not the signal is something actionable. Weekly options are extremely risky due to the high levels of gamma and time decay associated with them so often times a trader wants to pay close attention to large weekly options orders. Let s look at one such example in Boeing Co. (BA). The Trade:

11 This trade hit the tape on December 17 th just after 1 hour into the day s trading session. What makes this trade particularly interesting is that it took place the day before options expiration. The standard December options were expiring on the close the following day so this trader was coming in and making a 1 day bet in BA with this trade. This trade also required the trader to invest $205,425 of capital into the position. This means that this trader was willing to bet that amount of capital that BA would sell off by the close of trading the next day. We can also see that the trade that bought these paid through the market makers best offer at the time. The market on these puts was $0.47-$0.51 and the trader paid $0.55, more than the offer. This shows that his trader was very aggressive and was willing to pay up to make sure they got their order filled. This coupled with the very short time until expiration made this a very suspicious trade. While this is clearly an unusual order it is not automatically qualified as an actionable trade setup. To make sure this is an order that we actually want to follow we still need to run this trade setup through the OCRRBTT Trading Plan. Let s Look at the order again: Open Interest: As always we ended to make sure that this is an opening position. We can see here that the order is clearly labeled as such but if that were not the case we would still need a method to prove that the trade is indeed an opening position. To do this we will look at volume and open interest. In this trade a trader bought 3,735 contracts against open interest of only 575 contracts. This means that there were not enough contracts in open interest for this trade to be a closing position. This means that we can say with 100% certainty that this is an opening position. We would be able to determine this if the order was labeled or not. Chart: In some cases the chart is less important to the overall analysis. This BA trade is an example of that. While the chart of BA at the time of this trade was relatively strong we cannot put as much weight on the daily bar as this is an incredibly short term bet. This means that we need to use a faster time frame to get an idea of what the underlying trend is actually like. The overall context of the trade is also important. Remember we use the chart to determine underlying trend in an effort to filter out possible hedges from the orderflow we watch. In this case the context of the trade makes it less likely to be a hedge so the chart does not matter as much. This is a large bet with a very short time

12 until expiration so it seems very unlikely that a trader is buying this many BA puts for a one day hedge. Risk: This trade is somewhat risky because it is a weekly option that expires the next day. These options have a lot of exposure to time decay and gamma and can lose a large amount of their value with a small move in the underlying stock. Time decay will also happen aggressively on the last day of options expiration. With that being said these are still long options that were bought for $0.55. This means that a trader can never lose more than $55 per 1 lot in this trade. With that in mind a trader know that they do not have exposure to blowout risk and can move on with their analysis. Reward: These options have a high level of potential reward. As an options contract approaches expiration and moves to at the money the gamma in the position moves to its peak. These options expire in 1 day and are at the money meaning they have incredibly high gamma. This means that a small move in the underlying stock can lead to a large move in the value of the options contract. This means that a trader has the potential for a fast explosive move in the contract in either direction. Since this is an option that costs $0.55 we know what the downside is and can determine that the reward to risk ratio in this trade is not unfavorable. Breakeven: This contract expires the next day and has a breakeven point of $ The stock is currently trading at $ so the downside breakeven point is not too far out of reach. The stock only had the rest of this session and the next day s session to make this move but the breakeven level itself was not unreasonable so the order passes this part of the analysis. Time: This is essentially a weekly option. The expiration was the next day so a trader following along in this position would have to understand that this is basically a 1 day bet on downside in BA. All of the time decay and gamma considerations are still important to this trade. Target: This trader has a downside target below $147 by tomorrow s expiration. This means that I would want to trade the exact same strike as them. The trader that is executing this trade is risking a large amount of capital over a very short period of time. Regardless of what he knows this is the order that he picked and it is important to trade with that same order. The Results This trader turned out to be a huge winner. The stock sold off right after these puts hit the tape and closed near session lows.

13 The stock closed the session the same day that these were bought at $ and at the lows of the day these puts had more than tripled in value. What is so interesting about this trade is that this trader did not exit their position by the end of the day. Since we are able to see all of the orders that come across the tape in a given day we are able to watch for this trader s exit as well. Not only does unusual options activity help a trader with entries it can be used to time exits as well. With that in mind a trader has 2 options. They can lock in the profit they experienced in that same day or they could hold the position overnight with the institutional trader. While we never know exactly why a trader puts a position on this traders motivation becomes clear when the next morning to separate firms announced downgrades on Boeing (BA) stock and the stocked gapped lower on the open of regular trading the next morning. This trader held their position through that night and sold the majority of their puts the next day at $7.85 locking in an enormous overnight profit. Look at how the stock opened and traded the next day:

14 This trader was able to exit their position at $7.85 the next day locking in $2,745,225 in profits overnight. If a retail trader would have followed this institutional trader they would have locking in a net profit of $14,600 overnight if they took the institutional trader s exit. This is a huge profit on a relatively low amount of risk and a trader would have been able to track the institutional trader s entries and exits throughout the life of this trade. Other UOA Considerations We have now run through 2 great examples of unusual options activity using the OCRRBTT Trading plan to analyze the trade and determine if it is an actionable setup. The orders we have looked at are simple call or put buys but unusual options activity can come in many other forms. Institutions trade more complex orders and strategies and sometimes trying to figure out what they are doing can be difficult. There are also other steps a trader can take to find out more information on the trade and whether or not it is a significant as it seems. Open Interest Across the Chain We can get an even better idea of how significant an order is if we compare the open interest across the whole chain rather than simply using it to determine if a trade is an opening position. This can also help determine if a trade is likely to be a roll form an old losing position. The total amount of open contracts in a given options chain can give us clues as to how unusual or ginificant the order actually is. Look at the below chain and see how the largest

15 volume trade has happened against the smallest open interest. Then compare open interest in the entire chain. Does this trade seem as significant now? Volume Open Interest 80 8,000 5, , ,200 In this example the total open interest in the options chain shows us that the 5,000 lot of contracts being bought is not as significant as it might seem if standing alone. Not only can open interest in the options chain give us clues about the actual significance of trades it can also help us tell if the institutional trader is someone we want to be following. Consider the following trades: 5,000 XYZ Aug 50 calls sold for $0.05 5,000 XZY Sep 50 Calls bought for $0.45 OPENING The stock was trading at $48.00 at the time of the trade It would look like the trader is rolling their position from August expiry to September. Let s say that we know this an unusually large trade for this symbol. Do I want to take this trade? Look at the open interest structure. August Bid-Ask Open Interest Strike $0.00-$0.05 5, September Bid-Ask Open Interest Strike

16 $0.40-$ Looking at the open interest here we can determine that the first trade in August options is likely to be closing. We can also see that this trader is exiting their position for close to nothing. This tells us that the trader likely did not make money in the August options and is now trying to get tier money back in the Septembers. In our trading room we often jokingly refer to this as degenerate paper, because it represents unusual options activity from a losing trader. This is not orderflow we would want to follow. This type of rolling action can also be attributed to winning trades. This is orderflow we are more interested in. Look at the next trades: Sells 5,000 XYZ Aug 100 calls for $6.00 Buys 5,000 XYZ Sep 115 calls for $2.00 OPENING The closing options in this set of trades are being sold at a high premium level and are being rolling to further out of the money longer dated options. In this case a trader needs to ask themselves if it seems likely that this trader made money on the options they are rolling. Since they are being sold for a high amount of premium it stands to reason that this trader is more likely to have made money in this position. In this case the context of the trades we looked at completely changes how we interpret them. This is a great example of how orderflow should not always be taken at face value. Stock Volume and UOA Stock volume is also significant when analyzing unusual options activity. The less stock that trades in a symbol in a day the larger the impact of a large options order on the underlying will be. This is a concept known as stock control. The higher the stock control the more significant the options order is. For example if a trader buys 5,000 equity options they have the right to control 500,000 shares of stock. Consider the following. Example: A Trader buys 10,000 Aug 100 Calls in stock XYZ These calls have a 50 delta XYZ trades 300,000 shares a day on average How much stock does the market maker have to buy? What will happen to the stock?

17 To completely hedge themselves delta neutral the market maker in the above example will have to buy 500,000 shares of stock against the 10,000 calls they just sold the institutional trader. Since this is a relatively thinly traded name the stock could see a sharp move to the upside as the market maker buys stock to cover their position. This can create opportunities for day traders and swing traders of both stock and options. It also shows us when an order is particularly large and something we want to pay more attention to. Risk In Different Expirations From a risk management standpoint a trader also needs to realize that risk in a position changes based on the expiration of the options. The shorter dated the options position the higher the level of overall risk. Look at the example below. Understanding Risk In Weekly Options What has more risk? $10,000 in premium that expires in 6 months $2,000 in premium that expires in 3 days Although the longer dated position requires a trader to post 5 times more in capital the weekly options trade is much riskier because of high levels of time decay and gamma. Keep this in mind when trading unusual options activity and understand what your exposure to time decay at all times is. The Best Orderflow for You The best part about trading unusual options activity is that it is driven completely by institutional orderflow. The hedge funds, mutual funds, and large investors will trade every kind of options strategy under the sun. So a retail trader looking for institutional guidance via orderflow will be able to glean information on a whole variety of trade setups. The trades that come across the tape are relevant to different traders so it s important to follow the orderflow that makes the most sense for you. Pay attention to the orderflow most relevant to you: Day Trader Front month and Weekly Options (highest gamma) Swing trader Options with 3-6 months expiration (less time decay) Long term trader LEAPS

18 If you pay attention to the orderflow that is most relevant to you a lot of the noise : in orderflow will fall away. This helps a trader focus more on the information that is the most useful and relevant to them. The Orders to Avoid Institutions gain their competitive advantage from the large amounts of capital they have access to. This capital allows them to take trades with a high level of risk that is not suited for any retail trader. There are a lot of orders that hit the tape that a retail trader should avoid. Retail traders cannot afford to take as much risk as institutional trader and would avoid any position that could possibly blow out their account. The following positions should be avoided but could potentially be tweaked to fit in line with a retail traders risk appetite. Ratio Spreads: If we see a ratio spread hit the tape we know the risk is too high for us take the position. Here, we can adjust the trade to a butterfly. This removes the blowout risk, but stills sets up for the same market view as the institution. Naked Short Options: Naked short puts are less risky than naked short calls, but can still blowout an account. When seeing large orders for naked short options with an apparent directional bias, we have to consider selling vertical spreads in order to protect ourselves. Short Straddles and Strangles: The riskiest strategies are short straddles or strangles. If paper is selling straddles or strangles, consider selling the same straddle or strangle to buy a wider strangle. This would set up an Iron Condor or an Iron Butterfly. A trader would then be short premium and short volatility. By avoiding these trades a trader removes the chance of a blowout and will be able to stay in the game much longer. Conclusion There is no magic bullet in trading. A trader can however use unusual options activity to gain insights on the market that nobody else has. By following unusual options activity a trader can get a look into the world of institutional trading and reap the same benefits that they do without having to do the same hard work. This is simply a guide to trading UOA and the process of learning how to do it well can take a trader a long time to learn. Hopefully this book has provided you with a good starting pace to build from. To learn more about how you can Trade UOA with AlphaShark see the notice on the last page of this book.

19 Thanks Everyone and as Always Happy Trading! Team AlphaShark The AlphaShark Live Trading Room and Platinum Package Learn how to use unusual options activity to trade like top hedge fund managers and other institutional traders by watching professional traders trade real capital in real time all day long. The platinum package is AlphaShark Trading s premier subscription service and includes some amazing benefits. Platinum Package benefits include: Both of our Best Selling Ebooks Access to 100's of hours of members only videos Twice daily updates of all trades Real time SMS text messages of all entries and exits (please provide mobile phone number to get this) Access to the Live Trading Room from 9am-4pm ET Daily As a special thanks for reading this ebook we would like to offer you a chance to check out the trading room at a HUGE discount. Click the link below for more details. Click here to try the room!