Chapter 36: The Basics of Volatility Trading 745 
A SUDDEN INCREASE IN OPTION VOLUME OR IMPLIED VOLATILITY 
The symptoms of insider trading, as evidenced by a large increase in option trading 
activity, can be recognized. Typically, the majority of the increased volume occurs in 
the near-term option series, particularly the at-the-money strike and perhaps the next 
strike out-of-the-money. The activity doesn't cease there, however. It propagates out 
to other option series as market-makers (who by the nature of their job function are 
short the near-term options that those with insider knowledge are buying) snap up 
everything on the books that they can find. In addition, the market-makers may try 
to entice others, perhaps institutions, to sell some expensive calls against a portion of 
their institutional stock holdings. Activity of this sort should be a warning sign to the 
volatility seller to stand aside in this situation. 
Of course, on any given day there are many stocks whose options are extraordi­
narily active, but the increase in activity doesn't have anything to do with insider trad­
ing. This might include a large covered call write or maybe a large put purchase 
established by an institution as a hedge against an existing stock position, or a rela­
tively large conversion or reversal arbitrage established by an arbitrageur, or even a 
large spread transaction initiated by a hedge fund. In any of these cases, option vol­
ume would jump dramatically, but it wouldn't mean that anyone had inside knowl­
edge about a forthcoming corporate event. Rather, the increases in option trading 
volume as described in this paragraph are merely functions of the normal workings 
of the marketplace. 
What distinguishes these arbitrage and hedging activities from the machina­
tions of insider trading is: (1) There is little propagation of option volume into other 
series in the "benign" case, and (2) the stock price itself may languish. However, 
when true insider activity is present, the market-makers react to the aggressive 
nature of the call buying. These market-makers know they need to hedge themselves, 
because they do not want to be short naked call options in case a takeover bid or 
some other news spurs the stock dramatically higher. As mentioned earlier, they try 
to buy up any other options offered in "the book," but there may not be many of 
those. So, as a last result, the way they reduce their negative position delta is to buy 
stock. Thus, if the options are active and expensive, and if the stock is rising too, you 
probably have a reasonably good indication that "someone knows something." 
However, if the options are expensive but none of the other factors are present, espe­
cially if the stock is declining in price - then one might feel more comfortable with a 
strategy of selling volatility in this case. 
However, there is a case in which options might be the object of pursuit by 
someone with insider knowledge, yet not be accompanied by heavy trading volume. 
This situation could occur with illiquid options. In this case, a floor broker holding