Are you an option trader looking to make profitable trades? If so, then understanding the approaches used by experienced traders can be key to the success of your own stock options put trading.
We'll take a look at five uncommon steps that masters of the trade use when searching for great put option trades. From reviewing data volatility-based indicators and Greek option symbols to analyzing chart patterns and actively testing trades, these measures can help you make wise decisions about which options are best for consistent profits. By the end of this article, we’ll provide an example of a recent successful $LNC 10k puts trade idea that shows just how powerful these strategies can be!
Step 1: Find Unusual Options Activity
The first step to finding great option trades is to find unusual options activity. These are trades that are significantly different from the normal trading volume and activity in a particular stock. We use Cheddar Flow, a powerful options activity scanner that allows traders to uncover unusual options activity and follow the smart money in real time, to identify unusual options trading activity in real-time. Cheddar Flow's Dark Pool scans have been an immediate hit with the Masters in Trading membership. Start your free 7 day trial.
One example of the trades we found recently unusual options with unusually high interest the volume options traded in was Lincoln Financial (LNC).
10,000 $LNC May 17.50 Puts appeared on our basic starting call option scan: Stocks, Sweeps & OTM options.
The put options for LNC were purchased for $1.0 million, which price is considered significant and caught our attention. Trades of call options volume this size are done by institutional investors like a hedge fund. Based on the labeling from Cheddar Flow, the option volume is classified as a “sweep” and signal bearish put order flow. A “sweep” means these options were traded on multiple exchanges. However, we need to verify if this labeling is correct to determine if the trade is a bullish signal or bearish signal.
Step 2: Verify the Unusual Options Activity
After spotting unusual options contracts, we verify if it was a speculative trade or not by observing the stock price and market maker behavior after the trade. If the trade involved buying puts, market makers who took the other side of the trade would end up being long deltas, and they would have to sell the underlying stock to hedge their positions. This selling would push the stock price down on a short-term chart, confirming the bearish nature of the LNC trade. If the situation were opposite, LNC would have traded in the opposite direction.
In this case, we observed a short-term decline in the price of the underlying stock, and an order that was significantly higher total volume than the above average daily volume.
Step 3: Investigate Unusual Options Activity
The next step is to check for any unusual activity call options or news catalysts that may have caused the unusual call options or activity. This can include earnings reports positive results, company announcements, or industry news.
Head over to the company's website to see when the earnings report will be released. This unusual call options trade was done in the same expiration as LNC upcoming first quarter 2023 earnings release on May 9th after the stock market will close. The put options expire after the earnings announcement which increases the likelihood of short period of volatility, additional support of the recommended trade. Earnings season is an excellent time to find stocks with unusually high trading behavior. Pro Tip: Check the size of the option order relative to a companies market cap. A trade worth $5m, when a company has a market cap $200m is more powerful than the same trade on stocks with $AAPL or $MSFT.
Step 4: Analyze the Volatility Visualizer
Volatility Visualizer is a tool that tracks the expected move of a a particular security or stock around expiration date. We use this tool on Thinkorswim to get some understanding stock market move around where the stock is in it's expiration cycle.
In the case sell shares of LNC, the Volatility Visualizer showed that the expected move for the the stock price was around 4.5% over the next month. This implied volatility was in line with the out of the money puts that were purchased at the $60 strike price. This trade was likely a bet that stock's price of LNC would drop by at least 4.5% over the next month.
Step 5: Research Additional Information in Support of or Contrary to the Trade
Don't stop your trade research!
It's ok to find reasons not to do the trade, better to learn now than later.
In this case, additional research showed that pricing for $LNC’s Credit Default Swaps (CDS) significantly increased over the last few weeks reflecting market based increased credit risk supporting this bearish trade.
What is a Credit Default Swap (CDS)?
- A CDS is like an insurance policy for loans or bonds. It helps protect the person who loans money or buys a bond in case the borrower can't pay back the money they owe. The person who buys the CDS pays the seller a fee (like paying for car or home insurance). If the borrower can't pay back the loan or bond, the seller has to pay the money owed. The higher the fee, the riskier the loan or bond is. It's kind of like how you pay more for car insurance if you have a higher chance of getting into an accident.
Take a look at the chart below. What do you notice? The cost of $LNC’s CDS (the cost of insurance against default) has significantly increased over the last few weeks (doubling since early March) representing a significant increase in risk:
- This recent increased risk reflected in the credit markets is further support of this bearish put trade!
What do you think will happen to the price of the underlying stock of Lincoln Financial if the price of those CDS's continue to rise? Increased risk most likely takes down the price of the stock options the underlying asset of the stock.
To make a bet on the outcome and future strike price results of this predication we shared an options trade with the Masters in Trading community. The trade highlighted 5 reasons for entering the trade, and then was confirmed with future results of the continued share rise in CDS's next day trading move.
Synthetic Option Positions
Option synthetics are an integral part of the options market and provide traders with various strategies to manage risk and enhance returns. Knowing how to create synthetic positions allows traders to replicate the risk/reward profile of one security using another, potentially more cost-effective security. This knowledge is particularly crucial in identifying unusual options activity, as institutional traders, and hedge fund traders may use synthetic options positions to disguise their real positions.
Here are the basics of option synthetics and how they can be used to create various trading strategies.
- Option synthetics refer to a combination of two or more options or options with their underlying asset that create the same risk/reward profile as another option or underlying asset.
- Examples of option synthetics include:
- Long Call + Short Stock = Long Put
- Short Call + Long Stock = Short Put
- Long Call + Long Put with Same Strike and Expiration = Underlying Asset
- Unusual options activity needs to be interpreted because the smart money may use synthetic options positions to disguise their real positions. By doing so, they can potentially manipulate the market and take advantage of the mis-pricing of options. As a result, traders need to analyze the market activity carefully to identify potential hidden positions and make informed decisions.
How Traders Can Benefit By Following Unusual Options Activity
- Anticipation of a major event: If the trader sees option trading that has a significant impact on the stock price, they may be buying these OTM calls in anticipation of a large move in the stock. Knowing this information ahead of time can allow other traders to make strategic trades that take advantage of this expected price movement.
- Market sentiment: Large option trades can indicate a strong bullish or bearish sentiment in the market. Knowing this information can help traders anticipate future price movements and make informed trading decisions.
- Volume and liquidity: Large trades increase the volume and liquidity of the stock, making it easier for other traders to enter or exit positions. Knowing about this large trade can help traders make informed decisions about entering or exiting positions at favorable prices.
- Implied volatility: Large trades can also impact the implied volatility of the stock, which in turn can affect option pricing. Knowing about this large trade can help traders adjust their positions accordingly to take advantage of changes in implied volatility.
By following the 5 steps that Masters in Trading uses to have investors find great option trades, you can increase your chances of success in the options market.
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