The Research HUB: Options Market

Know the Flows

Hey everyone,

Ok, I have some exciting stuff to share!

A number of you have asked for more analysis and breakdowns of the options market. This article will delve in-depth into it, providing resources and then something special at the end.

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Resources:

First, you should go through all the educational articles that I wrote: link. These are great intros for the market and there are some good option books in there.

Second, read

Paper Alfa

’s recent article on option trading! Link. I would encourage everyone to Subscribe to his work. He is doing an exceptional job.

Third, I provided an article on gamma squeezes that frames a lot in terms of flows already: link

Fourth, if you are looking for an exceptional terminal showing options flow, I would suggest

Convex Value

. Here is their Twitter: https://twitter.com/ConvexValue . They have a lot of good tools!

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Some More Technical Insights:

When you are thinking about the options market, you need to remember it's simply another expression of positioning.

There is a great article breaking down HOW you need to analyze positioning and the float of any asset: https://teslainvestor.blogspot.com/2020/04/the-mechanisms-that-fueled-tslas.html

The example with Tesla applies to every asset. There is always some type of float and you need to identify what is constraining people in buying and selling. When we think about the options market, it's simply an additional instrument to express that.

Several technical comments on this relationship:

Open interest and stock float are related concepts, but they don't directly manipulate each other. Each of these terms represents different aspects of stock and options trading. However, options trading can indirectly affect a stock's trading characteristics, including its float.

1. Open interest: This refers to the total number of outstanding options contracts that have not been settled or closed. If the open interest of a particular option is high, it signifies that there is a high level of interest in that option.

2. Float: This is the number of shares of a company's stock that are freely available for trading by the public. The float is calculated by subtracting the number of closely held shares -- owned by insiders, employees, the company's Employee Stock Ownership Plan or other major long-term shareholders -- from the company's total outstanding shares.

Options trading can affect a stock's price, which could indirectly influence factors related to the stock's float. Here's how:

1. Exercise of options: If a significant number of options contracts are exercised, this can increase the amount of buying or selling of the underlying stock, which can drive the price up or down. Changes in stock prices can impact factors such as market capitalization.

2. Short interest: If there is significant open interest in put options (which give the holder the right to sell the stock at a certain price), it could suggest that traders are betting the stock's price will go down. This could potentially lead to an increase in short interest in the stock (the number of shares that have been sold short but not yet covered or closed out). Short selling can affect the stock's price and thus influence market dynamics.

3. Impact on supply and demand: If traders exercise a significant number of call options (which give the holder the right to buy the stock at a certain price), it could increase the demand for the stock. If the stock's float (the supply of shares) is low, this increased demand could drive the stock's price up.

However, it's important to note that while these factors can impact the stock's price and potentially the characteristics of its trading, they don't directly manipulate or change the stock's float. The float is determined by the number of shares available for trading, and this is not directly altered by options trading or the open interest in options.

Also note that the above scenarios are based on large-scale options exercising, which is relatively rare, as most options contracts are not exercised, and are rather closed before expiry.

Technical Comments on the Greeks, Implied Vol and Realized Vol:

In options trading, the Greeks are statistical values that provide a way to measure the sensitivity of an option's price to various factors. The main Greeks include delta, gamma, theta, vega, and rho.

1. Delta: This measures how much an option's price is expected to change per $1 change in the price of the underlying asset. It's often used as a proxy for the probability that an option will end up in-the-money at expiration.

2. Gamma: This measures the rate of change in the delta for each $1 change in the price of the underlying asset. It basically shows how much the delta will change given a price change in the underlying asset.

3. Theta: This measures the rate of decline in the value of an option due to the passage of time (time decay). It shows how much the option's price will decrease for every day that passes.

4. Vega: This measures sensitivity to volatility. It shows the amount an option's price changes given a 1% change in implied volatility. Unlike the other Greeks, Vega isn't named after a real Greek letter.

5. Rho: This measures sensitivity to the interest rate. It represents the change in the option's price given a 1% change in interest rates.

Implied and realized vol

Implied Volatility (IV) is a measure of the expected volatility of an underlying security. It's derived from an option's price and shows market expectation of future volatility. When implied volatility is high, options prices are higher, and vice versa.

Realized Volatility (RV), on the other hand, is the actual volatility demonstrated by the underlying asset over a specific period of time in the past. It's calculated using historical price data from the underlying asset.

The relationship between Implied Volatility and Realized Volatility is crucial to traders. If IV is higher than RV, it means the market is expecting the underlying asset to be more volatile in the future. If RV is higher than IV, it could suggest the options are underpriced, since the actual volatility has been greater than what the market expected.

However, just because IV is high does not mean that the realized volatility will necessarily be high. The IV is based on the market's prediction of future volatility, and predictions are not always accurate. Thus, a trader often needs to make judgments on whether the implied volatility is overestimating or underestimating the future realized volatility. This assessment is a key part of many options strategies.

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Ok Great, Technical Stuff Is Out Of the Way

We could spend a ton of time discussing option strategies, but here's the basic principle: when you're taking a view on an asset, you are considering the specific causal factors moving that asset. Options allow you to express your view with greater specificity, which can enable you to express trades in a clearer way and potentially offer better risk/reward.

If you want a resource on various strategies you can employ, read this: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247865

Some Additional Thoughts:

Much of the options market involves learning through experience. Options trade very differently on different assets. For example, you will notice that implied volatility behaves very differently in commodities compared to equities. We often see spikes in commodities that coincide with spikes in implied volatility. Usually, the opposite occurs for equities.

Before you trade any asset, conduct a study on its options market. Look at all the Greeks, how much open interest there is compared to the float, how open interest levels relate to volume levels and Globex levels, etc.

Here's the final thing I will say: many options traders tend to overcomplicate things. Of course, financial markets are complex, but there are a lot of very basic strategies you can employ with options. This is still a field in which I'm learning every day. Remember, always be learning! Just take it one step at a time.

Conclusion:

Special Announcement: I have models set up that monitor option open interest across all sectors and assets in the market. The best way to learn about this stuff is by observing and interpreting it in real time. I am going to start sharing more option-related flow analyses for paid subscribers. I will be working to incorporate more and more analysis and value into the pieces I am producing. As I have mentioned before, I intend to increase the depth and breadth of the analysis shared on this Substack. All of it will be from the viewpoint of a practitioner trading in the markets. Much of the analysis I will be sharing on options will be using the ConvexValue Terminal (link). I would encourage everyone to check it out!

Here is the article I recently wrote on Inflection Points and Peak Performance. I also provided some signals from one of the S&P 500 models I run:

Final thought for Paid Subscribers