Sometimes, Wall Street has a very convoluted way of looking at
things. For instance, consider the term smart money. One would
think the term smart money would refer to a professional
investor with incredible talent or a fund manager, market
strategist or analyst that has had consistent success over
different market scenarios, spanning many years.

Or perhaps a trader/investor who has an intimate knowledge of
the market and has mastered the tools of his trade, including
technical and fundamental analyses, hedging and option theory,
and an expert knowledge of the global economy.

Wouldnt this definition be a better fit for the term smart
money? Maybe, but not in Wall Streets eyes. On Wall Street,
the term smart money refers to someone with privileged
information, who uses it to their advantage. This person, fund,
or group doesnt necessarily have any special ability, talent or
expertise.

They only know something that the public has not been made privy
to. They have a piece of insider information that they sometimes
use illegally to profit in the market. It happens all the time.
So, on Wall Street, smart money is often synonymous with
cheating or illegal activity.

For many years, most professional traders and even individual
investors have studied long and hard in order to acquire skills
that would aid them in their quest to be better, more competent
traders or investors. However, not having access to the same
level of information as smart money sometimes puts the retail
investor at an extreme disadvantage.

A person with insider information has a crystal ball. He knows
the outcome of the game before the game is even played. The SEC
has rules in place to try to prevent this from happening but
these rules havent eliminated the problem because the SEC
cannot always prove their case. Therefore, there is still a
lot of smart money out there.
Most smart money traders try to keep a very low profile for
obvious reasons. The easiest way for them to do this is in the
options market where there are fewer participants thus fewer
eyes and ears to notice any unusual trading.

Further, the options markets offer much greater leverage,
allowing smart money to reap even greater rewards. For
example, If you knew that XYZ stock was going to report bad
earnings, and you knew this ahead of the market, it would be
much cheaper and more profitable buying puts in the options
markets as compared to just shorting the stock.

This is exactly what happens, and it happens more than you
think. The game is always easier when you know the outcome
before everyone else, and these smart money players are out
there making fortunes in the options markets because they know
what you dont.

Follow in the footsteps of elephants

What do we mean by this?

When a stocks option volume and implied volatility increase
significantly, it is often a harbinger of things to come.
Although the stocks price action may seem quiet and uneventful,
not reflecting any unusual activity, the stocks option activity
can be telling a very different story.

An unusual and greater than normal increase in option volume or
implied volatility can be an indication that large, informed
smart money players (the elephants) are placing bets on
upcoming events or announcements. These announcements can often
have a significant impact on the price of the underlying stock,
as with important corporate earnings, or other news.

These smart money traders or insiders who have privileged
information will try to act on this information before it
becomes public knowledge. The trading of options allows these
well informed investors to increase their leverage and enables
them to maximize their gains without risking their identity.

So how can we, as retail investors, benefit from this knowledge?

A significant increase or abnormal fluctuation in the trading
volume of a stocks options and/or a substantial increase in the
daily implied volatility of the stocks options can be a
precursor of a major movement of the respective underlying
stock.

Sudden changes in options volume and implied volatility can be a
tip off to potentially explosive moves in individual stocks. A
move of great magnitude is almost always going to be fueled by
news, but correct analysis of option order flow can alert one
before the news is disseminated to the public.

Often this type of news strikes hard at the heart of a companys
future prospects for growth and profitability.

Examples of these types of news are the following:

1 Earnings substantially better or worse than Wall Street
expectations
2 New product developments or breakthroughs
3 Mergers and acquisitions
4 Upgrades/Downgrades coverage by Wall Street Analysts
5 Media coverage
6 Products waiting for FDA approval or in clinical trials

And fairly often, this type of news is leaked. The people and
organizations who know about this information will use it to
their advantage. By looking for this unusual option order flow,
traders can spot unique opportunities and bank big profits just
by following in the footsteps of elephants.

There is more to this strategy than we will get into here, like
making sure that there is not also abnormal options size on the
opposite call / put options (usually just indicates hedging),
but it still can be a very effective clue to be aware of.

Since wagers are based on irregular movements in respective
companies, this strategys performance is not dependent on
interest rate stability, favorable stock market environment or
any other market factor. This may present major profit
opportunities, and returns can sometimes be far superior when
compared to other strategies.

Conclusion: this trading strategy analyzes options data for the
purpose of identifying significant increases (or abnormal
fluctuations) in trading volume and volatility of the stocks
options as an indicator of movement and the timeliness of that
movement in the underlying security. Options order flow analysis
can be an indicator of smart money positioning, prior to
publication of significant business announcements.

Another clue traders can look for are block trades on the TOS
(Time of Sales) reports. This is a related strategy, and does
not necessarily indicate insider buying, but can alert the
astute trader to large institutional blocks of options being
bought on either side of the underlying stock.

For example, if the average option trade size on a particular
stocks options is 5, 10, or 20 contracts, and you suddenly see
large blocks of 200, 500 or 1000 contracts going into the close,
then this is sometimes noteworthy and worth paying attention to
the underlying stock.