Option order flow is the study of monitoring the trades and volume from exchange traded equity options. This allows an investor to understand where different market participants are placing trades, and understand what their potential competitors are thinking. Although, monitoring flow does not give an investor the specifics to what someone else is thinking, it gives investors an idea of the volume, and the levels that market participants are following.
If a trader sells a call or a put, there is no way for anyone to know specifically what that transaction means. A trader can be adding or subtracting from current positions, legging into a position or hedging a position, it is impossible to know. In that case, the investor is not bearish at all; they are just selling a covered call to hedge or gain income. So, what information can be extracted from the trading in the options market?
Options flow can be of use and in many cases, the flow that is seen is a reflection of what the “smart money” is trading in the options markets. Of course, most of the volume is nothing more than speculative trading, such as initiating positions before an economic announcement or earnings release.
A large amount of the daily flow in the options market is by large financial institutions, mutual fund managers, and successful private investors, hedge funds, and other experienced traders. This group is well informed and uses a variety of different trading strategies that create numerous different types of risk reward profiles. Observing daily trading gives important insight into investor sentiment, and how investors perceive the future direction of a stock or a sector.
It is important to understand that there is no need to have two parties with different views to create a trade. Many times an investor will initiate a specific options trade, and if there is not another investor (in some cases called “paper”) available to take the opposite position, the market maker will assume the opposite side of the trade. The market maker will then hedge their risk in an effort to lock in some profit without keeping all of the risk.
Investors in anticipation of a move in an underlying stock generate most of the trading within the options markets and this is the basis for analysis or options order flow. Another underlying premise is the options market's price in the move in the options market by increasing implied volatility and raising prices. Implied volatility is an input within the options price model that estimates how much the market will move on an annualized basis, listed as a percentage.
Millions of options contracts trade on the US options exchanges each day. Each year, volumes continue to rise as more and more investors turn to the options market for opportunities. Some are looking for tools to hedge and manage risk, others are speculating to catch both short and long-term movements within the equities markets.
There are also options on futures contracts, which an investor can use to monitor the flow of commodities and interest rates. The Chicago Mercantile Exchange publishes options order flows for the majority of the futures contracts that trade on the CME.
Determining if another investor is opening or closing a new position is very interesting. Trying to figure out what other investors are doing by looking at the order flow can change the way you are looking at the market.
One important indicator of whether investors are buying or selling an options contract is whether the trade has taken place on the bid or the offer. The bid is the side of the trade where investors are willing to purchase an option or security and the offer is where investors are willing to sell an option or security. If transactions are occurring on the bid, then sellers are anxious and are not willing to wait for the market to move higher to lift their offers. If transactions are occurring on the offer, then buyers are anxious and are not willing to wait until the market moves to their bid.
The buying and selling can then be used to create an index that determines where investor sentiment on a specific stock or future is bearish or bullish. For example, if the options volume during the course of a day shows that 90% of the options where transacted on the offer, the sentiment for that stock is bullish.
Monitoring overall volume is another indicator that is important. When contract volume increases, as the market is moving in a specific direction, the volume is telling an investor that the flow is in the direction of the market move. If volume is light, then it is likely a weak signal.
There are a number of ways to track volume, most exchanges produce the data on a daily basis.