How to Make Money on Options Volume

In the spirit of our ongoing options education program, we like to answer as many reader questions as we can.

This one comes from George C. who asks, "Is there a way to trade options volume?"

The quick answer is yes.

Let's take a look at General Motors, for example. Shares were up more than 16% on Friday, and implied volatility fell on reports the automaker was likely to get more government aid. But there was also a steady stream of heavy put option buying (anticipating the share price to fall) in the April contracts, too. . . and for good reason.

Seriously, who out there thought the troubles with General Motors were over? And how many of us really wanted to give more taxpayer dollars to a company with a one-way ticket down the toilet? And did anyone really think the company would turn things around... or that G20 was going to provide further stimulus?

If your answers to those questions were no, no, no, and no. . . you see why the put options buyers were lining up to trade.

Or how about when we spoke of buying financial call options, as an Options Trading Pit trade? We were simply following the smart money when we bought calls on the Financial Select Sector SPDR (XLF) and the Direxion Financial Bull 3X Shares (FAS) calls, which returned 166% and 125% gains, respectively. And we were simply following the smart money because of coming news on mark-to-market accounting rules in early April.

Truth is, following volume spikes can provide significant profit opportunities. . . on both sides.

Technically reading a chart alone can show you who's in charge: the buyers or the sellers. Without knowing that, you'll have no idea who's in charge from one day to the next ― and you certainly won't be able to survive the options market.

Understand Volume Spikes. . . Identify Trends.

Oftentimes, analysts can see when a shift in momentum is about to occur simply by using candlesticks. A doji at the top or bottom of a trend can tell you that direction is about to shift. Or maybe a gravestone doji is parked at the top of trend, signaling near-term reversal.

There are lots of ways for detecting shifts. Candlesticks, which we just reviewed, can do that. Regular charting patterns can show "head and shoulder" formations. Moving averages. . . Bollinger Bands. . . Williams % Range. . . you name it, and it can be used to technically read for pattern shifts.

But if you want a quick read on whether a trend is strong, your best clue is in the volume. That's where we advise looking first because if volume is spiking, someone may be in the know.

Look at what happened with Forest Laboratories (FRX). Every time it touched its upper Bollinger Band, it was also met with heavy put option buying. We got a bit lucky with the latter portion of the chart, with about a $10 dive off a double top on the upper Bollinger Band. But match up the upper Bollinger Band touches with overbought W%R reads and you'll see the set up for a fall was in the stars.

 

 

And we made that money by not only following the technicals, but also by following the volume spikes in the put options.

The chart had already told me the story, technically. Volume-wise, the buyers of the underlying stock were tired. . . and ready to drop, which was confirmed by heavier option volume.

Lesson learned ― the next time you're tempted to buy options on a best stock that has been rising or dropping, be sure to check out the volume.

For more on options trading, we direct your attention to the following:

• How to Invest in Options

• How to Buy LEAP Options

• Options Intrinsic Value

• ETF Options Trading

• Crisis Investing

• Lockup Expirations

• How to Trade Like a Hedge Fund: Secrets of an Options Trader

Stay tuned for more options education next week, when we'll dive into naked options trading.