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