Spying on the insiders...

Guy Cohen is the creator of The Private Traders Club, Flag-Trader, The OVI Index and OptionEasy.  He is also the author of the best selling trading books "Options Made Easy", "The Bible of Options Strategies" and "Volatile Markets Made Easy" (FT Prentice Hall).

Guy specializes in stock market trading and he has created numerous online applications for stocks and options traders, with his hallmark being his user-friendly approach and liberal use of illustrations.  His clients include NYSE Euronext, The International Stock Exchange (ISE) and FT Prentice Hall.
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What’s the Best Way of Making Money in the Stock Market?

Well that’s a pretty open ended question.  First, it’s always best to specialize.  As with any skill in life, you cannot be a jack of all trades in trading.  

I specialized in options which has given me a rare insight into the activities of “informed” traders, which I’ll talk about later.  But before we get into that, we have to talk about stocks (which is my game).

For me, stocks presents the best opportunity of making windfall profits.  Take Darvas, William O’Neill, Zanger to name but a few.  In the stock market, massive fortunes can be made from relatively modest starting pots.

Now, what have those three superstars all got in common?  They all focused on one type of chart pattern.  The breakout from a consolidation pattern.  We can narrow this down even further by calling it a Flag pattern.

Flags

This is what I specialize in.  Flag patterns.  Breakouts from CLEAR areas of support and resistance.  O’Neill’s CANSLIM system of stock selection enforces very strong fundamentals behind a stock before it is even considered for the chart pattern I’ve just mentioned.  Meaning that any breakout would be underpinned by a rock solid financial performance of the company.  In this way – a bit like Buffett – O’Neill would have long periods of relative inactivity while the markets are “churning” before then getting busy as the patterns emerged.

This is one of the keys of trading success.  Patience.  Most of what we do it waiting.  Like a predator you simply have to wait until the right confluence of circumstances converges, and then … WHAM … then you pull the trigger!

So flags and consolidations is what I specialize in as far as chart patterns are concerned.

But what about all that options knowledge I accumulated over the years?

Well there’s one thing I learned later on, and that was the type of investors who gravitate towards the options market.  And once you get a sense of this, then you begin to see a whole new picture …

Informed Traders
Do you think it would be an advantage to be able to follow insiders and informed traders and spy on their activities in the markets?

Well the good news is that we CAN do that.

The question is … where do these smart investors congregate and how can we follow them?

Well, many experts talk about share volume and price patterns and they’re right on the money.  But there’s something else too … something even more powerful, and when combined with price patterns, far more valuable.   And that is options transaction data.

Now, don’t get concerned.  To monitor options transaction data doesn’t mean you have to know anything about options whatsoever!  Just understand that big, informed investors trade in the options markets … and this is where some of the most valuable information can be mined.

Before I tell you about that, let me ask you a quick question:

Why would the big, smart money get attracted to the Options Market?

Well, there are 3 big reasons:

1.    Their trades are relatively well hidden, and therefore they can trade discreetly.

2.    They can accumulate vast positions over a period of time without disturbing the underlying stock price.

3.    Leverage! – The ability to “control” a lot by investing a little.

Imagine you had information that you were sure was right on the money, what would you do with that information?

Well, you’d either invest more on the trade, OR you would look to get more leverage on it, which means options would be the logical investment vehicle.

It’s one thing to understand about options.  It’s quite another to simply observe options transaction data.  And that’s what is pertinent when it comes to assessing what the big money is up to.

A combination of options volume, open interest and implied volatility can give you a serious edge when it comes to monitoring what the big smart money is up to.  Provided you also have  proper trading plan based on well accepted chart patterns.

Understanding the options transactions enables you to tell what’s going on effectively below the radar.  It also gives you a feel for the market, especially when there are patterns forming of the kind that we like and specialize in.

Take the recent bearish market over the last few weeks.  I have been warning of this for some time.  Why?  Because I could see from the options transaction data that it was becoming bearish, and at the same time that I could see the bullish patterns struggling and breaking down.

Here is a blog post from May 24th, where I warned of more downside in the QQQ.

May 24th, 2011

QQQ

Tuesday's bar will appear in our OVI charts in a few hours time, so I've drawn it in by hand.  You can see that it's a consolidating bar from Monday's gap down.  This is looking like forming a flag type of pattern with the OVI Indicator continuing to be weak.  This could well set up some great trades for us over the next few days, both in terms of the index and its component stocks as well.  Support is well and truly broken and now is the time to hunt for bear flags for Nasdaq stocks.

Imagine having that kind of foresight for yourself?!

Take Goldman Sachs (GS) recently:

As you can see from the chart, the OVI was in negative territory from around April 14 whereupon the stock hovered right around and above $150.  During this time all you had to do was place a short trade contingent on $150 being broken to the downside … which is exactly what happened on May 9, after which the stock fell precipitously.

I could also see with GS that there was negative sentiment from the options transaction data I was looking at.  So I had a wonderful combination of a consolidation pattern forming around $150 and I could see the big players in the options markets were positioning themselves bearishly.

The OVI Indicator
How can I see the options activity so clearly?  Well there’s a little-known indicator called the OVI.  The OVI measures options transaction data and plots it as a simple line that bobs up and down between 1 and -1.  When the line is positive we’d be more inclined to observe bullish chart patterns and when it’s negative we’d focus the more bearish chart patterns.  We only use it in combination with a chart pattern such as a consolidation or flag.

The OVI is an oscillator derived from options volume, open interest and implied volatility.  It has nothing to do with the stock price, and yet the correlation is often astounding … and in many cases the OVI can precede the stock price.

The OVI is often a leading indicator.  This puts it at a huge advantage to the lagging indicators such as MACD, Stochastics, moving averages and RSI which are all smoothed by way of averaging several days of data.  This creates their lagging effect, which means often the indicators will signify something only after the market has made its move.

Used correctly in conjunction with chart patterns OVI demonstrates that the options markets will often be ahead of the stock market.  And when you are armed with that information, along with the proper trading plan, this can be a massive advantage.

If you enjoyed this article and want to learn more about the OVI, click here.

Cheers and best of luck in your trading,
Guy Cohen