Subscribe to Entrepreneur for $5
Subscribe

Fade Or Trade Unusual Activity?

There is another way to take advantage of unusual activity

By
This story originally appeared on Zacks

A popular options strategy is to scan the markets for unusual activity and then formulate a trading idea based on what that activity implies. This novel market environment is full of unexpected action with a the tidal wave of freshman traders moving markets (aka r/wallstreetbets), unorthodox public offerings (aka SPACs), boundless monetary stimulus, and an unforeseen penchant for ultra-high growth oriented stocks.

- Zacks

Screening for unusual activity generally involves options that had previously been very thinly traded but suddenly see a big spike in volume. The implication is that someone with knowledge about the direction a stock is about to move uses options to initiate a leveraged position that will profit from that move.

For instance, an out of the money call with small open interest and low volume suddenly sees a flood of buyers entering the trade all at the same time. Subsequently a buyout deal is announced, the shares rally and the formerly inexpensive calls are now in the money, producing a sizable profits for the buyer.

Of course, it’s illegal for someone to trade on non-public information and FINRA. The SEC is actually quite good at recognizing when unusual activity preceding a big moving event was a result of insider trading - and the offenders end up regurgitating profits and paying massive fines. These big trades are more likely to be the positioning of a big firm with good research than illegal "insider" trading.

The typical “unusual activity” trade would be to buy the same options that the big buyer just purchased on the assumption that a well-capitalized trader or big institutional buyer must know something valuable, and an individual trader can ride their coattails to profits by emulating the same trade.

However, there is another way to take advantage of unusual activity.

Fade it!

Take the other side - at least in the options market.

It sounds counterintuitive, but the implied volatility moves after a big trade can shift the odds in favor of an oppositional trade.

The option markets respond to big buyers by raising implied volatilities (and contrarily to big sellers by lowering them), which increases the premium you pay to purchase said contract.  

Let’s say there’s a big call purchase observed in the market. If someone buys a large quantity of a formerly thinly-traded call option, the implied volatility on those calls – as well as other calls in that same general vicinity of strike prices – is going to climb.

If you simply buy the same call after observing the big trade, you’re going to pay that new higher price.

If the trade is in a stock that you either own or would like to own, you’re probably better off selling a covered call.

You own the shares (or buy them) and then sell either the same call that the big buyer purchased or possibly one or two strikes higher. I’d look at the relative implied volatilities and choose the strike that was trading at the highest one.

This strategy allows you to still bag the long exposure to the stock you’re trading-one that a big market participant is betting on as well - but instead of paying the high price, you take advantage of the implied volatility move and receive the elevated option premium.

If the big buyer is correct about the timing and direction of the move and the stock rallies through your strike, you’ll collect a quick profit when the shares are called away at expiration. If the big buyer was wrong, you’ll collect the inflated premium on the option you sold, lowering your cost basis on the shares you wanted to own anyway.

So when you see an “unusual activity” options trade happening, consider that sometimes your best move might be to take the other side rather than simply executing a copycat trade.



Zacks Names "Single Best Pick to Double"

From thousands of stocks, 5 Zacks experts each have chosen their favorite to skyrocket +100% or more in months to come. From those 5, Director of Research Sheraz Mian hand-picks one to have the most explosive upside of all.

You know this company from its past glory days, but few would expect that it's poised for a monster turnaround. Fresh from a successful repositioning and flush with A-list celeb endorsements, it could rival or surpass other recent Zacks' Stocks Set to Double like Boston Beer Company which shot up +143.0% in a little more than 9 months and Nvidia which boomed +175.9% in one year.

Free: See Our Top Stock and 4 Runners Up >>



Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report

 

Invesco QQQ (QQQ): ETF Research Reports

 

SPDR S&P 500 ETF (SPY): ETF Research Reports

 

To read this article on Zacks.com click here.

 

Zacks Investment Research