When looking at option volume, how can traders tell whether a buyer or seller is initiating the trade? What about the intentions behind the trade?
Market watchers sometimes look to trading volumes in stocks and options as possible indications of market sentiment. For instance, relatively high volume accompanying a rise in a stock might indicate a bullish move with strong conviction. Conversely, relatively low volume accompanying a rise in a stock might be seen as bearish or lacking conviction.
Some market watchers might argue that stock and option volume in isolation doesn’t offer much in the way of true information. But when volume—particularly relatively high volume—is analyzed in connection with other common statistics, it might just offer a glimpse into the thoughts of influential market participants.
Volume is the number of shares (for stock) or contracts (for options) that are exchanged between a buyer and a seller. And although there’s a buyer and seller for every transaction, we’ll assume that one of the parties took the initiative in executing the trade and is therefore the more aggressive party.
If, for example, XYZ 50 calls suddenly trade 5,000 contracts compared to an average daily volume of only 500 contracts, then one might ask, “Why all the action?”
Without looking at other variables, such as implied volatility and open interest, volume itself really doesn’t mean much. It doesn’t answer any questions about who’s behind the trade or, more importantly, their intent. Is it one major buyer of options? Or the collective volume of many smaller investors? How do we know whether the buyer or the seller is initiating the trade?
Implied volatility and open interest can help to start providing some potential answers. If the implied volatility of an option sees a substantial increase compared to the other options around it, then this might imply the buyers are more aggressive. Conversely, decreasing implied volatility might indicate an aggressive seller of the option. Trades completed in a few big blocks compared to many smaller trades might indicate an institutional investor versus individual retail investors.
Open interest is a statistic that indicates the number of contracts outstanding. This number can help determine if option volume is an opening trade or a closing trade. If open interest grows, then it might reveal that investors are taking larger positions. Declining open interest, on the other hand, shows when positions are being closed. So if you see heavy volume with rising implied volatility and growing open interest, then you might presume that there’s an aggressive buyer of those options. But even then, is that really telling you something?
It’s impossible to really know the intent of any market player simply by looking at the numbers. For instance, let’s assume that there’s an aggressive institutional investor buying XYZ 50 calls, and that it’s an opening trade based on increasing open interest. Could this seemingly bullish trade simply be a hedge for a bearish short stock position? Yeah. Could it be one leg of a trade where the other part of the trade isn’t as obvious? Sure. The possibilities are endless.
Maybe high volume means something, and maybe it doesn’t. The thinkorswim® platform offers tools for options traders who are looking to run scans for unusual volume or open interest. But don’t simply look at unusually heavy volume or high open interest and jump to conclusions. Do your research. Look at implied volatility, open interest, and other statistics to get a clearer picture of what’s possibly going on.