Using Options To Tell The Future

| December 28, 2011 | 0 Comments

Can you tell the future just by looking at options?  Unusual question, but the answer may surprise you.

Option volume can be very useful in determining the direction a particular stock or ETF might move.  And it's an indicator you should watch when analyzing your own portfolio.

Let me be clear, I’m not talking about trading options, just looking at option volume.

In short… the key is to look at options on your stocks to identify unusual volume activity.  If done correctly, it can tell you a whole bunch about potential future movements in your stocks or ETFs.

And that's what it's all about, information for you.

Now, let me walk you through an example of how I do it…

For instance, with energy stocks so volatile lately, I've been focusing my attention on the SPDR Select Sector Energy Fund (XLE).  I know it’s about to make a big move, however, the direction is a bit elusive.

So, first I go through my normal analysis as a routine trader.  This includes looking at ETF volume, momentum and technical indicators. This information will show if I even want to purchase XLE.

In this case, it just so happens, XLE's technicals are what have been hanging me up.

As you can see, XLE is trading in a range between $65 and $70.  The shares have been bouncing up and down in this range for several weeks.

I would love to know if XLE is poised to break out to the upside.  And I'm just as interested to see if the ETF is going to bounce off resistance and head down again.

This is when I go to the option chains.

After I pull up my option chain, I look at several strike prices and months.  Here's what I found for XLE.

As I write, XLE just finished the day at $69.20, up 1.2%.  I found that more than 100,000 XLE options traded yesterday, that's the equivalent of 10 million shares.

As I continued to hone in, I saw the December quarterly expiration (December 30th, 2011) $65 put options topped the action with 22,600 contracts changing hands.  One block was purchased for an average price of $0.14 per contract.

So, what does all this mean?

First off, since these traders bought puts, it would automatically tell me XLE is probably going lower.  In addition, when I see large option blocks trade at very cheap prices ($.05-$.25), it usually spells speculation.  In other words, traders making large bets that a particular stock or ETF will make a large move in their direction sooner than later.

However, large put transactions don't always mean the underlying stock or ETF is heading lower.  If I saw the same trade executed for $1 or more, it would probably indicate something else.  For example, it could mean traders are selling put options to collect the premium.  In that case, the option activity would signal a bullish outlook for XLE.

You see, it’s very rare traders speculate on stock direction for over $0.25.  It's not practical.  And it's simply too expensive.

Bottom line…

Over my 15 years trading options, I've found option volume trends to be an accurate indicator of the underlying asset's next move.  So, next time you're thinking about buying a stock or ETF, take a look at the option volume and see if there’s any unusually heavy activity.  It just might give you the clue you need to determine where the stock or ETF is headed in the near-term.

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Category: Options Trading

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