Updated: Apr 23, 2020
It continues to amaze me day after day how insightful option volume can be in the futures and equity markets. Today alone, there have been four crude oil ($CL) option volume alerts generated by our option volume indicator that have provided actionable data to inform our trading decisions.
Real World Examples from January 31, 2020 (highlighted in the chart above)
At 9:09 and 9:10 AM EST, there were two large call volume spikes in $CL futures. After determining they were mostly made up of buys, we shifted our bias to the upside and waited for price action to confirm. Both candles made lower lows, with no sign of any impact on sentiment by the large option purchases. This intense selling pressure coming at a support level made a larger statement than the call volume itself, sellers were in control. After confirming price action to the downside, $CL dropped in price from 51.96 all the way to 51.62.
At 11:47 AM EST, there was elevated put volume determined to be mostly put buying in $CL. After seeing sellers step up and force price action downward, price dropped from 52.16 to 51.99.
At 12:08 AM EST, there was a large spike in call volume that was most likely call buying. However, this large increase in bullish activity had almost no impact on price action. Upon seeing price break below the fairest price of 51.85, the signal to trade short was immediately evident. This price action resulted in a price decrease from 51.85 - 51.15.
Just like any other indicator, you cannot take option volume at face value. Just because the "smart money" makes an entry at a certain level, we can't always be sure of the time frame of their trade or the type of trade placed.
These reasons are why you must read the context of the market based on price action and levels of support and resistance. The combination of auction market theory and option volume makes trading much more understandable and straight forward once you understand the key concepts.
Below are the rules we recommend in order to interpret option volume and its effect on short term price direction:
1. Be aware of the nearest two levels of support and resistance on either side of the current price. We recommend using market or volume profiles to find high volume nodes. These high volume areas are where most trades are transacted and provide good levels of support and resistance. In addition to high volume nodes, the previous period's point of control, value area high and value area low provide excellent S/R levels. You can manually draw these price levels or you can use our customized volume profile that will plot these levels for you.
2. Locate fairest value using a market or volume profile. Fairest value (point of control) is the price at which the highest volume of the time period has been transacted. This price level tends to act as magnet for balanced markets and as a repellent for trending markets.
3. Await an option volume spike. After receiving an alert for elevated option volume, review the Option Time & Sales chart on the Trade tab near the bottom. We use this chart to make assumptions about the direction of the underlying calls and puts. If a trade is marked in green font, we assume this was a buy transaction. Alternately, if it is in red font, we assume it was a sell. Transactions with grey font are purchased/sold around the mid price and an accurate assumption cannot be made regarding its direction. Locate the trades for the calls or puts spike. If the majority of the trades or trades with the highest quantity are green, then we make the assumption that these were buys. We assume these individuals were bullish (bearish) if calls (puts) were bought. We can assume the opposite for sell transactions.
4. After analyzing the call (put) volume in the Time & Sales and making a determination on its likely direction, review the price action to confirm this volume spike is changing (increasing) the current market sentiment. If you see a call (put) volume spike, where buying (selling) occurred, this would give you an immediate bullish bias. However, wait for confirmation from price action before confirming your bias. If sellers continue to drive the price down in the face of strong bullish option activity, this indicates the sellers are in control and are out in force. However, if buyers show up after the option volume spike, then this indicates a change in price direction and a good long entry point.
5. After confirming the price action direction, review the nearest S/R levels to determine if there is an appropriate risk to reward opportunity for the trade. If you see bullish option activity and price action trending higher but you are 5 ticks from a resistance level, wait for the resistance to be broken to the upside before placing a trade. Obviously, this varies based on your risk appetite but we recommend waiting for room to run in order to increase your return to risk ratio.
6. Exit criteria will vary based upon your skill and risk appetite. We recommend using a stop loss as the markets have been especially volatile as of late.
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All provided information is for educational purposes only and should not be construed as investment advice.