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Trading with the ‘Smart Money’

Trading lends itself to an analysis of data because there is so much data available.  Technicians plot prices (the most common data used).  But there are those who believe that volume tells the story.  Much data is available, and there is someone, somewhere who believes that he/she has found the ultimate investment technique – based on data analysis.  And perhaps that person has done exactly that.

One frequently discussed piece of data is trading volume.   For stocks, there's upside volume (paying the offer) and downside volume (selling the bid).

Options volume data offers more variety.  There's not only buy/sell volume but there's separate data available for puts and calls.  That allows the popular put/call ratio to be calculated.

Heavy volume often results is a rapid increase in option premium and  implied volatility.  (They come as a package; you can't have one without the other.) 

If you are into analyzing numbers, there are plenty of numbers available.

The point is that there's lots of data and some traders, analysts, journalists love to use volume data to forecast future stock price changes.

At times a surge in trading volume precedes a big price change.  The best example of this occurs when people with inside information buy huge quantities of options, choosing puts or calls, based on what they know.  Of course this is against the law and with today's technology, the perpetrators usually get caught. 

Many times this 'smart money'  – defined as money invested by experienced people; especially when they have inside information – is invested by stupid people, who are about to face big problems when caught trading on this inside scoop.  When this money enters the marketplace, the volume surge is predictive.  In other words, insider's information is accurate, and the stock moves accordingly – once the news is released. 

But this doesn't happens often enough to assume that an increase in volume has any significance.  If you always go along with a large volume increase, you will win on those rare occasions when the volume surge is the result of people who know something.  Most of the time there is no reason to assume anyone knows anything when you see a report of large trading volume in a specific option series (a single specific option) or class (all the puts or calls of a specific stock).

Recently there was a good discussion by Adam at the Daily Options Report about a surge (make that a tsunami) in call volume for two stocks.  It was all very innocent and involved an attempt to capture the dividend (a play that's not for individual investors – and that's why I have not mentioned it previously).

"The big trade Tuesday was massive call volume in Verizon and AT&T, particularly in the January in-the-money (ITM) options that basically carry a 100 delta (i.e., they are virtually stock). In fact, volume was so high that it dwarfed the pre-existing open interest in both names.

To add even more intrigue, both names found themselves all over the news wires thanks to Google unveiling the new Nexus One smartphone.

At first glance, you might be thinking this looks like smart money loading up on calls.

Nope. It's just some dividend-capture plays."

But, that volume might have made speculators to believe some monumental deal was about to be announced or that the entire industry was about to get some outstanding news.  As is often the case, the volume meant absolutely nothing.

Another example occurs when a stock owner decides to write covered calls or buy some puts for protection (or perhaps do both by trading a collar).  These large trades have no predictive power because the person making the trade is just taking insurance on an already-existing investment.

Don't follow the action, hoping the big trade is being made by 'smart money.'


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