The Myth of “Unusual Option Activity” (Part 2)

Last time, I suggested our inability to identify all components of a position prevents us from making valid conclusions based on volume and open interest data.

Another source of uncertainty when we see unusual option activity is whether options were bought or sold. This was Christine’s question on the Option Alpha article. Purchases and sales both count as volume. Open interest is even more complicated because not only can purchases and sales both change open interest, either can increase or decrease open interest depending on whether a position was opened or closed. If the underlying is so thinly traded that I can see what pieces match up in terms of spread legs and/or underlying share/contract volume then I have a liquidity disaster waiting to happen. This may be a position I can enter with ease but should I be forced into a rapid exit, hefty slippage may await me at the door (think Black Flag’s Roach Motel).

Although it sounds eloquent, I do not even believe “as one piece of the trading puzzle, option activity is worthwhile to follow.” Whether I ever want to make a bullish or bearish conclusion from volume or open interest data, reasonable doubt to the contrary will always exist. For this reason, I should always be skeptical about strategies that use only big prints as trading signals. I should also beware confirmation bias in any advertising of this (or any) strategy when all coverage is given to profitable trades and none given to trades gone bad.

In other words, beware optionScam.com when unusual option activity is purported to be a source of profitable trade ideas.

My personal belief is more often than not, inexperienced retail traders will be the ones blindly following “unusual option activity.” Instead of following the smart money, this approach may lead them into a crowd stampede with the general public only to become a loss leader on the general ledger.