follow the smart money

How to Use Options Flow to Trade Along with the Smart Money

The financial markets might be highly regulated and provide everyone with an equal opportunity to trade, but as a retail trader, you are almost always at a disadvantage compared to the market makers, institutions, funds and large traders — otherwise known as the “Smart Money”.

The Smart Money Advantage

  • The Smart Money has access to information that you don’t, and they see public information before you do. That means they place their trades and move a stock on news before you have a chance to act. When you do finally try to trade the news, they are usually taking their profits, at your expense.
  • The Smart Money (specifically market makers) can see the order book, which displays the current buy and sell orders and their quantities, so they know exactly where the stops are located — and can push price to those levels to trigger those orders.
  • The Smart Money has the financial power to move a stock price, especially if the trading volume is light, and draw retail traders into buying or selling a stock, only to then rip the stock in the opposite direction.
  • The Smart Money can use the media to print or broadcast analysis, rumors or even fake stories to draw traders into a position and create the liquidity they need to profit from their own position.
  • The Smart Money can, in rare situations, actually change the rules and regulations to save themselves from losing. Some recent examples of this have been preventing retail traders from either buying or selling specific stocks — remember Gamestop and AMC?

Trying to beat or outsmart the Smart Money is futile. The only way for a retail trader to be truly successful in trading is to be able to identify and align yourself with the Smart Money.

There are several ways to follow the Smart Money, including technical analysis and volume analysis — both of which help identify major stock moves that can only be made with Smart Money participation.

Another powerful tool that can help level the playing field and provide a way for retail traders to follow the Smart Money is options order flow analysis. By understanding and utilizing options order flow, retail traders can gain valuable insights into Smart Money sentiment and potential.

In this blog post, we will explore how to effectively use options order flow to trade along with the Smart Money.

Using Options Flow to Trade with the Smart Money

Options order flow refers to the analysis of the incoming buy and sell orders for options contracts. It involves monitoring the volume, direction, and timing of these orders to gain insights into market participants’ intentions and sentiment. By examining options order flow, traders can uncover valuable information such as institutional buying or selling, unusual activity, and the overall sentiment of market participants.

In order to follow and analyze the options flow in real time, you’ll need access to a service that provides the data you need. The one I use is BlackBoxStocks.

Identifying and Interpreting Smart Money Activity

1. Transaction Size

Below are large options trade in PXD (Pioneer Natural Resources) that took place on 5/22/23 and 5/23/23. On 5/22 over $730k of calls (almost 1000 contracts) with a strike price of 215, expiring on 7/21, were purchased in 2 large trades (the bottom 2 lines of data). On 5/23 it looks like 217 of those contracts (the white line) were sold and rolled into the 225 strike for the same expiration date. This type of large call buying can only indicate Smart Money activity. No retail trader is laying out that type of money on options!

from Blackboxstocks.com

There’s a lot more to analyze about this particular options flow data set but, for the purposes of this post, we have enough data to know that some Smart Money player is betting that PXD is moving higher by July 21. You, as a retail trader, can buy a few calls and ride along on the coattails of this Smart Money player.

It’s worth noting that Smart Money players will sometimes split up a large order into multiple smaller sized orders. That means you might see a bunch of smaller dollar amount orders in the same strike and expiration that actually represent a single player — so you’ll need to break out your adding machine to see how big the actual play really is.

BEWARE — there is absolutely no guarantee that Smart Money bet will be right — OPEC or other world events can easily change the trajectory of oil and the energy stocks. And there’s also no way of knowing what other positions this particular Smart Money player has, and whether is particular play is not just a hedge or a piece of some other larger strategy — which would invalidate the benefit of following it.

But trading is a game of probabilities, and this data gives us enough ammunition to place our bet in the same calls as the Smart Money player is buying.

2. Unusual Options Activity

Sometimes you’ll see some relatively large options transactions — calls or puts — in a ticker that rarely see any options flow. That’s what you would call unusual options activity. It’s often a signal that someone knows something about the ticker that you don’t.

You might ask, how can they trade on non public information? Isn’t that illegal?

Well, what can I say. Legal or not, the fact is that in many cases a piece of “unexpected” news comes out soon after those options are acquired, in the direction of the trade. I’ve seen many cases on unusual call buying a day before an analyst upgrade or a buyout is announced.

Did someone trade on proprietary information? That’s up to the SEC to figure out.

The only thing that matters to us retail traders is to follow the lead of the Smart Money.

3. Intensity of Options Activity

Another thing to watch in options flow is the urgency or frequency of the trades.

A single options trade, even with substantial size, is something to notice but might not be something to act on. But when multiple trades come in, within a short period of time, at the same strike and expiration, it indicates a sense of urgency. These Smart Money players really want to get into this position, and they want to do it asap. Maybe you should consider tagging along for the ride?

Using Options Flow for Stock Trading

You don’t have to trade options to benefit from using options flow. You can buy or sell stocks based on your interpretation of the flow. For example, in our example of the PXD options flow, instead of buying the 215 calls expiring in July, you could buy the stock and not have to deal with time decay or implied volatility fluctuations.

The options flow can also help you time your trades, based on the expiration dates of the options being traded by the Smart Money. Weekly options indicate short term trades while expiration dates with lots of time indicate longer term trades.

Bottom Line

No matter how fair the market seems to be, the Smart Money is going to come out ahead most of the time. If you want to trade successfully, you need to be trading with the Smart Money, not against them. And one of the way to follow the Smart Money is to analyze options flow. With the right tools and training, you can do just that — and trade in sync with the Smart Money.

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The tool I personally use to track options flow is blackboxstocks. If you want to follow the smart money, this is a great tool for doing that, which will easily pay for itself if used properly. They also have a very useful chat room that goes along with the scanner. They're running a huge holiday sale now for up to 50% their regular monthly price. Click here to get the deal.
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