Option or Stock-Which Moved First?

Option Trading Topic: Which Moved First, the Option or the Stock?

Dear Options Trading FAQ:

Ok, intuitively, it makes sense that option activity has an effect on the stock prices, but when I try to figure out exactly what the effects are, and why, I get confused quickly. For example, suppose stock XXX is trading at 42 and Jan 40 call options are going for 2.75. Now say I buy 100 calls at 2.75, what effect will this tend to have on the price of the underlying stock, and why?

Eager to Learn more about Options Trading:

Dear Eager Beaver Option Trader:

Good options question. The fact that this issue is on your mind shows that you are well on your way to properly using option pricing as an analytical tool. Here is the concept in a nutshell. Then, I’ll get into the mathematics behind it.

First, let’s assume that because of the fantastic leverage inherent in the options, someone with advance inside information will seek to profit by it through playing the calls or puts. Because they have the scoop in terms of expected price movement and timing, they will move into specific options instead of blanketing the entire call side or put side. This makes for characteristic cash flows that experienced option trackers will recognize as smart money moving in.

Now for the theory part. For those that have experience working the Black Scholes theoretical option valuation model, you know that the volatility factor is the hardest input to deal with. If you simply take some sort of historical average (10, 30, 60, etc. time periods, weighted or unweighted), it is not satisfactory in that the result won’t jive with the up-to-the-minute floor analysis. So the pros use the formula backwards to come up with an implied volatility figure. That is, enter the current market price along with the other factors and solve for volatility. We are letting the current trading price of the option imply the volatility.

Do this on an ongoing basis and you can track the expectations for the stock through the volatilities implied by its options.

If the implied volatility jumps all of a sudden without any stock news, pay attention! Someone is bidding up the options. Perhaps they know something?

This, combined with study of volume trends, can tip you off that something is going on in the stock. For example, if you notice that today’s number of call options traded is double the average total daily volume of all contracts, pay attention! If this occurs without any news on the underlying stock, suspect that news is upcoming.

In your example, the call option purchase will raise some eyebrows if 100 contracts is unusually big. Do large option blocks usually occur in this issue?

What is the average volume of options traded? Is there news on the stock? Is it a volatile stock with lots of interest? Option analysts have a whole list of things to look at in determining the import of your purchase. The underlying question is whether your trade represents smart money that should be followed.

Typically, the option watchers will check to see if the trade was a straight purchase or part of a spread. Also, they will look for accompanying volume in other strikes and months. Usually, 100 contracts is not considered a lot, but if persistent volume follows, the analysts will be interested. Of course, your purchase (and any subsequent others) will push the bid/ask up and that will show up on everyone’s theoretical valuation model. The implied volatility will increase, signaling an alert to option fanatics around the world. If deemed significant, the trade will serve to put the stock on many players’ watch lists.

Some may buy the stock right away on a hunch, driving up the stock price a bit.

So, you see that in the case of a stock that has no news, a significant option purchase will move the stock up. The option purchaser is considered to be ahead of the stock in terms of anticipating possible good news.

This is just the rudimentary approach to option tracking. The experts will also run screens based on comparisons of today’s option price against all sorts of historical averages and stats. The field is a complex one with many opportunities for innovation.

PS. I fondly remember the antics of one wealthy options client who used to drive the analysts absolutely batty. On nothing more than a hunch, he would place an order for 1,000 HWP Calls, 1,500 MOT Puts, or worse yet, 1,200 Calls on some thinly traded issue on one knew about. The floor people would call asking if we knew if something was about to happen with the stock. The option analysis screens would spit out alerts based on our own buying. I suppose all sorts of panic ensued all around the country based these option volume swells. It just goes to show. When a system based on logic meets the unpredictable workings of the human mind, not everything is what it seems. Be careful!

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Valuation, Options Pricing

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