Understanding Option Volume Trends with Market Chameleon

Will McBride and Dmitry Pargaminik, cofounders of Market Chameleon join IBKR’s Senior Trading Education Specialist Jeff Praissman to discuss what data points they look at when analyzing option volume trends and how to decipher the data.

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Note: Any performance figures mentioned in this podcast are as of the date of recording (December 14, 2022).  

Summary – IBKR Podcasts Ep. 53

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi everyone, welcome to IBKR podcasts. I’m your host, Jeff Praissman, Interactive Brokers’ Senior Trading Education Specialist. It’s my pleasure to welcome back the co-Founders of Market Chameleon Will McBride and Dmitry Pargamanik. Hey guys, how are you?

Dmitry Pargamanik

Pretty good. How’s it going?

Will McBride

Hey Jeff, thanks for having us, buddy.

Jeff Praissman

Oh, it’s my pleasure. It’s great to have both you guys back in the studio. You guys have a long history with Interactive Brokers. I’m excited now that clients can subscribe to Market Chameleon directly through Interactive Brokers.

Dmitry Pargamanik

Yep, that’s right we started our integration with Interactive Brokers. Part of the first step was to allow Interactive Brokers customers to subscribe directly from Interactive Brokers to Market Chameleon. This way, you don’t need a credit card, you get an extra 30-day free trial, it makes it much simple to connect right to your account and the idea there is that eventually we’ll create a way to link your account to Market Chameleon and then it should be seamless as far as your senior positions and risks within Market Chameleon.

Jeff Praissman

That’s going to be great and today. we’re going to discuss a topic that’s near and dear to all of our hearts, trends and option volumes.

Dmitry Pargamanik

Yup.

Jeff Praissman

And so let’s kind of start off and … what are currently the more, most popular option?

Dmitry Pargamanik

One of the things we do when we look at the volumes in the options … we kind of try to understand “What are the traders doing out there?” What are the investors doing now out there? Where are they concentrating on?” and of course, some of the most popular options happen to be the most popular stocks you hear in the news such as TSLA, SPY, QQQ, META. All those usually are the top 10 busiest volumes as far as options go, and there’s a really big concentration of volume in those top ten. Just to give you an example, there are currently 5,913 equities that have listed options, but the top 10 alone make 50% of the volume in the option space … so very concentrated on those popular names. If we go down a little bit further and take the top 100 stocks, then we’re talking about 80% of all the options volume.

Jeff Praissman

When you say buy, there’s really two types, right? There’s the notion of the dollar volume, and then there’s also the contract volume. So for example, if the contracts were $0.10 you have to buy ten of them to equal one that’s worth a $1 to equal the same notional volume. And you know, in what does each one show? If someone’s looking at options, why would they look at notional? Why would they look at contracts? Obviously, why would they look at both to sort of get the full picture?

Dmitry Pargamanik

Yeah, there are two different ways people look at the options volume. One is just to take the raw volume, the number of contracts that traded and of course, within that you’re going to get options that are going to vary in the dollar amount. Some are very low, some could be very high, so the next step is that people look also in comparison to the dollar volume in the trades and that kind of gives you an indication how much actual flow in dollar value is going into the options market. And that would be the difference like you explained where you could have an option that is $0.10 that traded 10 contracts and then you could have an option that’s $100 and traded 10 contracts but in dollar terms it’s a big difference. And you’ll have two types of traders, one that can afford to trade 10 contracts for $0.10 and another type of trader will not potentially be able to afford to trade 10 contracts, $100 per contract, and that’s why we take a look at volume from 2 perspectives: the total volume and then converting that volume to dollar notion.

Jeff Praissman

So, it’s really just to make sure that you’re looking at apples to apples. In other words, 100 contracts of a $10 option versus 100 contracts of $100 option contract are very different things.

Dmitry Pargamanik

Exactly, very different things.

Jeff Praissman

And also, I’d actually put in to … like I would say, another factor would be the trade count, right? Like how does that factor into statistics?

Dmitry Pargamanik

Yeah, and the next thing we break down in the volume is the number of trades it took, and you could have volume that is 1 trade but 1000 contracts or you could have 1000 contracts and 1000 different trades. Of course, 1 trade 1000 contracts could be a big institution that traded one time, but if you have lots of different trades, that’s an indicator that there could potentially be a lot of interest from different players, and that’s kind of the sense you’re trying to get. Is it just this one-time big trade, somebody put on a position, a hedge, a speculative position or are we seeing interest from lots of different traders coming into an option?

Jeff Praissman

So, just to kind of recap right now for the listeners, you guys, when you’re looking at the volume, you’re first looking at maybe the contract volume and then breaking down to the dollar notional volume and then also the trade cuts. So, all these are important statistics that go into you painting a picture of the option trend but then of course, as anyone familiar with the options knows there’s also different expirations covering different time frames and then also other factors as well. So what are some of the telling facts as far as like if you’re looking at expirations with trends where you’re seeing throughout different expirations?

Dmitry Pargamanik

What we’re seeing is that more and more of the volume is gravitating to the shorter-term options. Really, when you look at the options that expire within 5 days, they’re seeing about 5 — I’m sorry — about 50% of all the options volume, and as you get closer to 0 days to expiration option that expires at the end of the day, you even see a bigger concentration of volume within those five days. And that is showing up of — traders are looking for options that have a lot of Gamma and high Theta and you know, an option decays. So, when an option decays it doesn’t decay linearly, if you have an option with 10 days to go, it’s a dollar, it doesn’t decay $0.10 a day. It’ll decay slower in and as you get closer to expiration that decay will accelerate, and of course the last day the entire thing will decay. So, option sellers are looking for options with the high Theta that decays really quickly and then option buyers are looking for options that have a lot of Gamma because as the option gets closer to expiration, the Delta, it starts moving almost in lockstep with the stock as it’s in the money. Of course, if it goes out of the money it expires worthless and that’s the trend that we’re seeing. That more people are starting to gravitate to the zero DTE or options that expire same day.

Jeff Praissman

Just for our listeners. That may be a little bit unfamiliar with options in like the Greek terms … Theta is relating to time decay, and Gamma’s relating to change in Delta. So just kind of giving our listeners that are maybe more new to options a little bit of background.

Dmitry Pargamanik

Right, that’s what the trend is. They want options with very high sensitivities … sensitivities to decay, sensitivities to the movement in the stock price.

Jeff Praissman

So then, kind of given that like as far as — Taking a step back as well, like the fact that they do offer daily options now and in several big ETFs and weekly options in, I don’t know how many symbols, but the majority of symbols. I mean, you know, 15 years ago there were 12 expirations a year for equity options and now for some of these ones there’s 252 expirations I guess you could say.

Dmitry Pargamanik

Right.

Jeff Praissman

So, do you think kind of the chicken before the egg or the egg before the chicken?  Has creating these multiple expirations in your opinion, drawn more people into option trading? Or has the fact that as more people or option volume increases, exchanges have increased the expirations to kind of cater to and satisfy the crowd of traders?

Dmitry Pargamanik

Yeah, definitely. I think that the exchanges are reacting to the customers’ demands and where they’re seeing the demand, they’re starting to create products around there. That’s why they’ve been creating more strikes. You know, [at} one point we only sell strikes that were $5 apart, now we have dollar strikes, half dollar strikes, and now they’re creating more, shorter dated options. The one thing I think the Cboe is starting to do is expand options trading in the indexes to potentially go 24/7. In the SPX, we see trading in the options in the pre-market in the after-hours and one of the reasons you could do it in the indexes is because those options can get hedged with the futures. The stock options will be a little bit harder because they stop trading after 4:30. You do have after hours trading, but they’re liquid. But the first step in the indexes, we do see the Cboe offering extended hours trading in the options.

That’s the other demand that we’re seeing, but definitely the shorter dated options are very popular, and I think that they also became popular as more small retail traders started to trade with Robinhood. They brought in a lot of new retail customers. They created new accounts and got people, introduced to options and we do see that about 20% of the options volume right now are coming from what we would designate as small retail traders with … not a big bank account. I would say maybe they’re a smaller bank account, maybe just starting to learn what an option is. Not a very sophisticated trade, you know, much more speculative and we’re seeing about 20% of that coming from small retail, but the retail space alone I think, makes up almost by our estimate, 50% of the options volume, and that’s a lot. It’s a lot of retail trades coming in into the options market, and that retail looks like they mostly trade in the short-term options.

Jeff Praissman

And I mean it’s interesting that you talk about these smaller retail investors. And judging by the names of the more popular options that you talked about in beginning this podcast, they really are all household names there.

Dmitry Pargamanik

Right.

Jeff Praissman

There wasn’t any, company in there or index that most people haven’t heard of. You mentioned Tesla and Meta, and these are all – Google — like all these are all companies – Apple — that we regular people use every day or at least know exist.

Dmitry Pargamanik

Right.

Jeff Praissman

What are — Obviously household names as it is, seems to be a big part of option volume trends, but what other items can factor into either an increase in a spike in volume or a decrease in volume, even if it’s only for a single day or a single time period? Like obviously you have your popular companies, but there’s times where a company that maybe no one’s heard of or isn’t as popular, spikes up there and becomes a Top 10 or Top 20 option trend for the day or for the week or for a month or whatever?

Dmitry Pargamanik

Yeah, and you will see that certain stocks they will spike in volume, and it could be based on news that came out recently and that news can drive traders to come in and use the options to either hedge their positions or use the options to have certain outlook on the stock. Earnings are big and in earnings you usually see volume picking up probably couple days prior to their earnings event, and there’s a certain strategy that people use options for to play earnings. Earnings is a binary event, they come in, they know the event is coming up, so the date is known. It’s also known that when a company releases earnings that is information that’s used by the market and the stock will usually make a big move reflecting the new news. Some people do play earnings using options and there are different strategies that you could use around earnings, and that’s actually very popular around earnings to use options in different strategies.

Biotech companies, also, when you see something in a biotech FDA, when they start releasing information or waiting on a ruling people will go in and use the options to play that volatility. So certain things like that, we do see a pickup in volume, but that volume usually will disappear after the event, and then that that volume will drop off and it’s only playing that specific event. From day-to-day, though, you’re right, it’s usually the Top 10 and what’s interesting is that Tesla right now is the number one on our list of the most active options, and if you look down below Tesla, you got SPY.

If we just compare the notional dollar value of the options going into Tesla versus SPY … you got Tesla, just today, you could see $1.7 billion worth of options traded. SPY, which represents an ETF of the entire market, the next busiest, is $850 million worth of options traded. A big gap between the one and two. Even going down to the next one, the third one down, QQQ, that’s $356 million worth of options. So, you could kind of see going from the number one down the list, it starts to drop off significantly as you’re going down the list. Very big concentration of trades in a very few products. That’s what so far, we see.

Jeff Praissman

Now is there a way to tell through statistics? You had mentioned … especially talking about the retail investor, that a lot of it’s probably speculative where they’re doing these short-term options. What about like — Obviously, options are powerful tools well, for hedging an existing position. — Is there any way to tell from these strategies being traded? Or say, the overwhelming volumes to puts, that they may be hedging a position or is it sort of more you sort of have to really just take a lot of data points and make an educated guess at the end of the day about what you think the trend is?

Dmitry Pargamanik

Right, what we see is it would be hard to tell what the actual intent is of every trade. If it’s if it’s hedging a position or if it’s taking a certain outlook in the market, it would be very difficult to tell because we wouldn’t have enough information. One encouraging sign we do see is that there is growth in the multi-leg strategies such as call spreads, put spreads, time spreads. That’s encouraging because when you start spreading off options, you’re also … what you’re doing is decreasing some of your risk in the in the option trade. You’re going to spread off some of your Delta risk, some of your Vega risk, and when you’re doing that, it actually decreases your risk and if you applied it the right way you could get your probabilities a little bit more favorable than just doing a single leg option, because when you’re doing a single leg option, you’re assuming all the risk that that one option has: the Delta risk, the Vega risk, the Theta risk, the Gamma risk. But, by doing multi leg trades you’re going to reduce some of that risk and actually improve your odds, and that’s what options really … if you take a look at options … advantages of them, the most powerful thing about options is being able to trade option one option against another option, right? That’s where you kind of start finding opportunities when you could spread off one option versus another option. That’s encouraging, but a lot of people when they first come in there, they just take strictly a bet, I think, on direction using an option and they’re assuming all that other risk: time risk, vague risk, and so forth. And a lot of times they are using those options inefficiently to try to bet on a certain direction.

Jeff Praissman

So, really when looking at option trends it it’s safe to say as you see, multi-leg strategies increase, it’s a sign that either more institutional traders are involved in the market or professionals or that even retail traders are becoming more sophisticated and more educated as far as trading a strategy that will give them a better probability of a better outcome versus just throwing a dart at the board and saying “I’m going to buy some Tesla calls because I like your company.”

Dmitry Pargamanik

That’s right.

Jeff Praissman

“I think the company is going to go up in the next 5 days.”

Dmitry Pargamanik

Exactly, that’s right. When you start seeing the traders educating themselves more and figuring out how to use spreads, they usually don’t go in the other way. They don’t go back to single leg options, they’ll stick to that and build on top of that, because that is really value that you get from the options, and you’re not taking advantage of it and involves a little bit more education but if they’re willing to do the work and they’re willing to understand the different strategies, and you could start out with just a simple spread, right? You don’t need to go to four legs right away, or three legs or ratio spreads, but we always say if you could start out with a single spread, a call spread or put spread and learn from there, then you’re on your way to I think doing much better and becoming more successful than if you just stick to something that’s simple. And when something is simple, doesn’t necessarily mean – If it’s something simple to understand, doesn’t mean it’s the best thing, right? It’s just simple to understand and a lot of times when people just figured that out, what is a call? They don’t want to move to the next step, because even that was hard to understand, right? What is a call option or what is a put option? They figured it out, they want to stick with that, but really you got to move your education a little bit further to improve your odds. And we find that those that don’t do that usually, either see failures pretty quickly or eventually you know they’ll start to learn there’s a better way to do it. But that yeah —

Jeff Praissman

And I’ll say, and by definition really putting on a spread is going to is going to limit your risk, but it’s going to offset some risk for you, for the investor, versus just doing a single leg option.

Dmitry Pargamanik

Exactly.

Jeff Praissman

When you continue to look at the option volume trends, clearly, on any given day we talked about sort of obviously the usual household names, and then the event driven reason for volume such as news or earnings. What do you look at as far as knowing … because Tesla could be at the top of the list everyday right … but clearly today you mentioned it has 170 billion or whatever it was and tomorrow it could be 3 billion. So, what do you look at as far as comparing how even those top 10 or whatever place the option is in compares to what it was in the past?

Dmitry Pargamanik

We try to keep track of the rankings in the volume and the trends, and we see what’s climbing. For example, Coinbase right now is climbing, especially with everything going on in the crypto and what’s happening with the other crypto exchanges. Coinbase, it has been climbing in the rankings. Sometimes you see a few stocks that will make the news, and they’ll climb, and they’ll stay there for maybe a week or two and then you’ll start seeing that volume disappearing, but we try to keep track overall what is going on and why is it going up?  If it’s going up because of earnings, we’ve already expected that, and they’ll come back down. But what’s going up? Why? And why would people gravitate to that stock?

So, like right now with interest rates, we do see that some of these bond ETFs, the volumes are ticking up there. People are paying attention trying to figure out where interest rates may go based on inflation measures, where the Fed may take interest rates going forward and we’re seeing a little bit of uptick in some of the semiconductor space. The news there and what’s going on in China, what’s going on with legislation, we have seen an uptick there. Some of the things when we check … for example, you’re asking about hedging, are people using it to hedge? Are people using the options to speculate?

You could also compare the volume from the previous day to the open interest and how much of that volume converts to an increase or decrease in open interest. And what we’re seeing is that there’s a very high turnover or — I guess how would you say it when there’s — It’s probably a low turnover of volume that actually translates to an increase or decrease in open interest, so there’s a lot of volume, but the open interest doesn’t always change that much and what that’s telling us is that people, even intraday, are just rotating in and out of positions. And when we see a big SPY trade happening as people start trading the at-the-money and as the stock is moving, they’ll rotate out of that at-the-money to the

Jeff Praissman

I kind of want to wrap up the discussion with one last question, and it sort of, I think, circles back on a few of the points that that we discussed. How does volume correlate to quote width? And the conclusions I’m drawing just from our discussion, — correct me if I’m off base here – but essentially, if something is trading because it’s a household name, it’s popular and there’s no real news event, but it’s like SPY or it’s TSLA, I would assume that a higher volume is a more liquid option and the quote width it’s probably tighter versus possibly with a news event. Or whether it’s an earnings release, whether it’s a biotech FDA report that’s about to come out saying that phase four of the test or it’s failed … I would almost think that could adversely affect the quote width and make it wider because there’s so much uncertainty and people are trading these options for very different reasons between household names and event driven events.

Dmitry Pargamanik

Yeah, yeah definitely. The more volume you see in the stock, the more those bid-ask spreads shrink and that’s because that’s part of the discover the price discovery process. As you get more people trading and narrowing the bid-ask spread and there’s a meeting of the minds, it’s much easier to kind of price where people think the options should be priced. Of course, some of these stocks that have zero volume in them, there’s no price discovery. It’s probably a market maker or specialist. There’s one model, you know that that they’re running. There’s always uncertainty in the model, and you’ll see a big bid-ask spread until more people get involved, but definitely the more volume something has the, the more the bid-ask spread starts to shrink. The more the bid-ask spread shrinks, the more people get involved right? Because people actually scan for that, and some people do not want to trade anything with a big bid-ask spread because of the fee to trade is very expensive.

Jeff Praissman

Well, Will and Dmitry, I want to thank you very much for stopping by IBKR Podcasts. A reminder to our listeners that all podcasts can be found on our website under the Education tab or on Spotify, Apple Music, Amazon Music, Podbean, Google Podcasts and Audible. Also, Market Chameleon is a frequent contributor at our webinars, and webinars can be found at ibkrwebinars.com. Select our contributors and click on Market Chameleon for all their past webinars. And also, Market Chameleon hosts a daily morning show on YouTube as well.

Dmitry Pargamanik

Thank you, Jeff.

Jeff Praissman

Thank you guys very much.

Will McBride

Thanks for everything Jeff, a great job.

Jeff Praissman

Until next time, I’m Jeff Praissman with Interactive Brokers.