Profiting From Unusual Options Activity?

Unusual options activity is a large block trades that represent a large percentage of daily option volume. The majority of unusual option activity can be traced back to hedge funds, mutual funds, and other large institutions. Knowing where these institutions are placing their bets can be hugely advantageous for any trader. But is it really the case? 

The problem is that we don't know the real reason for those big trades. Was it a pure hedge? Was it some company insider selling stock to finance his child college? Maybe it was part of previous transaction (for example, someone did a bull put credit spread, and a week later did a bear call credit spread, to complete an iron condor)? Or someone is buying puts or selling calls against a new long position. 

Our contributor Chris shared some thoughts about unusual option activity on the members forum. Here is an extract from his post.

I looked into this a long time ago (over 5 years), and got no where with it.  MOST of the "unusual" options activity you see pop up from time to time is hedging activities by large funds and/or institutions -- not by individuals or even funds having inside information or taking large directional based bets.  These often do not coincide with stock purchases as they may be merely locking in gains.

Simple example:

Fund A bought 5m shares of MMM in January 2013 at $95.00.  January 2015 it hits $165.  You could have bought the two year put leap at $110.00 then for under $1.00 - or higher at higher strikes, thereby locking in guaranteed gains. 

Or Fund B has a maximum draw down of X% allowed on a particular position before closing it as a trading rule.  So when it opens a position that it has long term beliefs on, but may be highly volatile in the short term, it buys the puts 10% down. 

You wouldn't want to trade based on that unusual option activity -- at all.  In either case you would actually be betting AGAINST what the institution did.  One of the case studies I did followed a sap who learned that two VPs of a large company were buying huge quantities of put options after watching UOA and reading disclosure reports.  The first thought anyone has is "holy crap the company's officers are betting against their own company" and made a trade against that.

Whereas in reality, these two VPs were about to have a ton of their employee options vest -- at an acquisition price MUCH lower than the current trading price (perfectly normal in employment agreements), and wanted to hedge their soon to be stock position at the high price. 

The truth is unless you know who made the UOA, why it occurs, and the holdings of the entity/person making it, you simply are just guessing.

The ONLY exception I've ever seen to this is in a few pre-announcement trades -- typically that occur within 5 minutes or so pre-closing.  I have done no studying on this, but have at least ten examples I've personally noted on trades I watched -- on earnings announcement day, all of a sudden, five minutes or so before the market close, you see a huge option purchase of slightly out of the money calls or puts -- and then an adverse/unexpectedly positive earnings announcement -- that always proves to be right.

However, even then, while the directional move has always proved correct, it has not always led to the "trader" (e.g. inside trader) making money due to volatility collapse.  Even if you know there's going to be a bad earnings surprise -- do you also know how much the market will move in response to that?  If volatility is quite high leading into earnings, even knowing a move is coming might not result in profits. 

The bottom line is that blindly following the “big” money simply because of large options trades can be a dangerous game. The activity could be simply hedging against the traders larger position in the underlying.