Unusual options activity (UOA) is a useful tool for forecasting hedge funds and large institutional money movements. Many stocks undergo such activity during earnings season, as the current call options may begin to move closer to an “in the money” position depending on the financial statistics presented. And as traders attempt to profit from the increased price, demand will rise.
What is an Unusual Options Activity?
The appearance of anomalies in the options order flow is termed “unusual options activity.” When volume is significantly higher than the historical average, options market activity can be considered unusual.
Institutions, hedge funds, wealthy investors, and other experienced traders account for a large portion of the daily volume in the options market (“smart money”). This group is astute, well-informed, and employs a range of tactics. Observing their everyday activities can provide valuable information about important future movements in stock, a sector, or even an entire market.
The Case with China ADRs and Cannabis Stocks
Various events, such as public events, earnings announcements, company conferences, product launches, geopolitical tensions, legislation, the exit of a key executive, and so on, might cause unusual options activity. Traders may base their allocation choice depending on such occurrences. Furthermore, they might dispose of proprietary information to back them up.
China ADRs and Cannabis stocks have seen high unusual options activity recently. One is said to be the result of a combination of geopolitical tensions and regulations, while the other is most likely the result of forthcoming legislation.
China ADRs have recently seen a significant drop in value due to concerns about delisting and the overall US-China relationship. This resulted in a surge of unusual options activity, driven by the market's dread of uncertainty. The Direxion Daily FTSE China Bear 3X Shares (YANG), which tracks the FTSE China 50 Index, recorded 378.32% above-average volume, as depicted in the graph above.
To put this uncertainty in context, it comes after the United States approved a law in December 2020 mandating U.S.-listed Chinese businesses to let financial audits be reviewed by watchdogs such as the Public Company Accounting Oversight Board. The Holding Foreign Companies Accountable Act gave companies and their auditors three years to comply with the law.
China has barred domestic corporations and their auditors from complying with international regulators' inquiries. The resulting tensions have grown since then and virtually paralyzed a once-vibrant market for Chinese listings in the U.S. According to Goldman Sachs, U.S. institutional investors have around $200 billion in exposure to Chinese ADRs.
On the flip side, there has been a spike in secondary listings of Chinese companies in Hong Kong in the last three years, including Alibaba, JD.com, Nio, and NetEase.
However, the outlook for China's ADRs is still bleak. Regulations may make it much more difficult for Chinese companies to list in New York, with uncertainty about audit procedures and new Chinese rules on offshore listings clouding the chances for fundraising.
The unusual options activity reflects this, as investor sentiment and appetite for Chinese assets have been near rock bottom for the past few years.
Cannabis-related stocks have been in the spotlight recently, with significant levels of volatility. For example, Aurora Cannabis (ACB) has seen unusually high options trading activity lately. On March 24th, the stock recorded 93,770 option volume, compared to the 20-day average of 11,943.
This can be explained by the MORE (Marijuana Opportunity, Reinvestment, and Expungement) Act, which Congress is expected to vote on shortly. Chairman of the House Judiciary Committee Jerrold Nadler presented the bill to remove cannabis from the federal list of illegal substances.
It is worth noting that a previous version of the Act passed the House in 2020 but faltered in the Senate. Therefore, investors are wary of the outcome of the current vote, which also helps explain the stocks' volatility. Nonetheless, in case the Act goes through, it will have an astonishing effect on the sector, as cannabis companies would finally be able to transform legal marijuana sales into actual earnings for their investors.
Looking at Canada, which legalized cannabis in 2018, industry stocks have followed similar growth patterns to those seen in the United States.
The stock price skyrocketed throughout the timeframe of the Act's enactment, as shown in this graph. However, the high point did not endure long, and the rate of decline has continued since then. Although it may not reflect the upcoming trend in the United States, investors should remain cautious since the rise could be fleeting, even if the Act passes the Senate.
Unusual Options Activity May Signal Money Moves
In conclusion, unusual options activity could reflect significant market players' money moves. Therefore, knowing how to interpret such activity can be an effective tool for forecasting future stock changes. Nowadays, many technological tools allow to track unusual options activity easily.
Nonetheless, investors should be wary of market timing strategies, as none can guarantee a specific outcome. Unusual options activity should be only utilized to complement an existing strategy, as it is not a precise science.
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