Friday, March 27, 2015

caveat emptor on unusual otm call volume

there's this rumor going around among option traders that 25% of all otm calls are insider trading. this rumor derives from the andrew ross sorkin story from last june (study asserts startling number of insider rogues) in the new york times. this rumor is a misrepresentation of the facts and can be dangerous to your trading success. here's why:

first of all, the 25% number relates to the percentage of m&a deals in which unusual option volume preceded the announcement, not the percent of otm call volume. go to the link and rewatch the video. 

however, i think there has been an increase of manipulative option trading that relies on traders believing the rumor. here's how this unfolds: a hedge fund forms a bearish opinion on a stock, they wish to short the stock but need to protect themselves in case the stock goes up. so, the hedge fund first buys a boat-load of cheap otm the calls. the unusual volume on the call options is trumpeted by a number of robotic news agents that constantly scan the option chains for just such an occurrence. the reports draw-in traders who are looking to get in on the "insider-trading" and also purchase the calls and/or stock. this new buying pressure easily raises the stock price by the amount of the cheap-o options and more. then the short selling begins and all the weak-hand retail traders get stopped out, helping to propel prices downward.

just raising the stock price by the amount of the amount of the option price paid by hedge fund gives them free insurance for their intended short stock position. if the stock price can be driven to the break-even price of the option then the intended short-stock position will be risk-free, because no matter how high the stock goes the now itm call options can be exercised to cover the short at break-even. 

every once in a while i find myself looking at this unusual otm call activity too. recently, i fell for this manipulation on the ticker, king, even though i knew it was wrong. what if i was wrong? i didn't want to miss out! 

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