Are you an options trader or looking to get into trading options? Options can be overwhelming and seem over-complicated to those just starting. One tool often utilized is the options flow, which shows large orders of contracts bought and sold by institutional investors.
But there is much discussion about whether it’s helpful or even works. Some options traders swear by it, while others think it is just noise that shouldn’t be used to enter or exit a trade. As with most things, the truth probably lies somewhere in the middle.
This article will examine the options flow and explain why it may or may not matter for options traders.
As we know it, options flow is essentially a running transaction record of large volumes of options contracts being traded. This data is available in real-time and provides information about the number of contracts traded, the strike prices, and the expiration dates. When looking into options trading, traders need to know these essential elements.
It’s a great tool to determine where big institutional money is flowing. It also shows the general sentiment of institutions toward a particular asset or the market overall. It can track the trade flow of stocks, ETFs, commodities, the Volatility Index, and even broader indexes like the S&P 500.
You can see why some traders think options flow is extremely relevant, and it is. There is no doubting the power of this information as it can give you an insight into where the big money is headed. But as you will see later, some key elements are missing from the options flow that might change your mind.
What to Look For in Options Flow
Options flow can be broken down into several key components that traders analyze to gain insights into market sentiment:
Trading Volume
Why is volume important? It shows the total number of options contracts traded during a specific time frame. As you might expect, higher options volume means significant institutional interest in that particular stock or ETF. As with most things in options trading, volume is used by traders to gauge potential future price changes in the asset. Be careful because volume isn’t always predictive and can sometimes lead you astray.
Strike Price
The strike price is like the compass for options trading: the key price at which options traders anticipate a move by the expiration date. Again, this doesn’t necessarily show us the whole picture. Options contracts can be closed before expiration, so the asset’s price never has to reach the strike price.
Expiration Dates
Along with strike dates, the expiration date is the most important part of an option contract. This is the key date by which a decision must be made on the trade. It can be closed, rolled, or exercised depending on the trader. Most options contracts never expire, so take these with a grain of salt when reading options flow.
Put-Call Ratio
The put-call ratio is an important measure of the current market sentiment for an asset. Logically, if the put-call ratio is skewed heavily to calls, it is a bullish market. Likewise, if it is skewed to puts, we can assume there is potentially bearish sentiment in the market.
Open Interest
Open interest is the key to a more complete picture of options flow. This is the total number of outstanding options contracts that are still open and have not been closed, expired, or exercised.
A high open interest shows confidence in open positions being held by traders. This is a great indicator that the current trend is likely to continue. Once these traders begin closing their positions, open interest will decline, and a change in the trend is likely to occur.
What Can We Learn?
The Market Sentiment
This is the obvious thing we can glean from the options flow. Major market participants buy and sell millions of dollars worth of options in a single trade. These are institutional bets or hedges on how an asset will perform. The call flow is bullish, and the put flow is bearish. While this is not always black and white, this does give us insight into how market makers view particular future assets.
Institutional Bias
Option flow doesn’t always tell us what institutions are thinking, but it does show us the current bias of smart money. Learning how to read option flow is a skill and not just a matter of saying calls are bullish and puts are bearish. It is reading the entire flow of the market and determining which trades are significant and which are hedges.
Risk Management
Protecting your portfolio and applying proper risk management is always prudent for traders. Option flow can tell us when there is a change in market sentiment or bias from institutional investors. This makes it easier to apply hedges to mitigate the downside risk during a volatile time in the market.
How to Read and Analyze Option Flow
Use Option Flow Platforms
Option flow platforms like Unusual Whales or Black Box stocks are great for watching the flow both during and after trading sessions. While options flow data is available in some places, these platforms provide a fully customizable experience as well as additional tools like heat maps that can enhance your analysis of option flow.
Focus on Unusual Trades
Unusual options flow are significant orders in size that could potentially have an immediate impact on the underlying asset. There is a lot of noise from day to day on the options markets, so isolating the unusual trades is the best way to stay on top of the major market-moving trades. Unusual trades are usually more than \$1 million in size and of major stocks or indexes like SPY or QQQ.
Cross-Reference with Technical Analysis
One mistake a lot of traders make is just trusting option flow without back-checking it with any technical or fundamental analysis. In this case, technical analysis works because major options trades have a high correlation with important technical spots on charts. Check for areas of support or resistance that can help determine a nice setup for that option trade.
Limitations of Option Flow
So far, we’ve reviewed why option is an important tool for any trader’s arsenal. But like any form of analysis, option flow is not perfect. Let’s look at some of the limitations of option flow and where you should be wary of using it.
Option Flow is Not a Guarantee
This is the single most important thing to know about option flow. It’s not a crystal ball nor a perfect prediction of where the underlying asset’s price will go. There are plenty of losing institutional trades, so following all of them is not a get-rich-quick scheme. Option flow should be used to enhance and supplement your trading rather than being your only source of information.
Block Out the Noise
There is a lot of noise in the options flow; not all are useful. These institutions make trades daily, sometimes entering and exiting positions in a single session. It’s nearly impossible to tell if the flow is a multi-leg trade, a sweeper, a block, or just a hedge against a larger long-term position. As we said, learning how to read option flow is a skill, and part of that is learning to block out the noise.
Potential Market Manipulation
We’re not wearing a tin foil hat here, but there could be some potential market manipulation in the options flow. Why? Because institutions know that retail traders follow option flow and use it to guide their trades. If they wanted to, they could manipulate the flow to make it seem like they are bullish or bearish on a position while trapping retail traders. We’re not saying it does happen, but it certainly could!
Final Thoughts
Option flow can be a great tool for traders looking for insight into market sentiment and institutional bias. It isn’t always a perfect way to follow trades, but it is certainly more helpful than harmful for option traders. Learning how to read and analyze option flow is a great skill. Not all the flow is useful, but you might be surprised at how often these trades work out.
Check out our trading community today to learn more about options trading and flow!
