The View from the ‘Virtual Pit” by Mark Oldani: Following Orderflow

Following order flow, if done correctly, can help a trader make (or not lose) quite a bit of money. Gone are the days, unfortunately for market makers and pit traders, when one exchange traded a product so all the information was in a fishbowl. Back then, since the product only traded on one exchange, the trader saw every order that traded in that product. Now almost every product is listed on 5 exchanges or more. However, there are still ways to follow how the paper is trading. For one, keeping an eye on implied volatility levels is key in seeing how the flow is affecting option prices. This is achieved by watching the “supply and demand” of/for options.

Going back to SEB’s article on flow where he used an example of AMZN 2 quarters ago, the buyers of the 105 calls were coming out of the woodwork.

Notice All of these purchases were on the offer

The stock price rose gradually throughout the day pre-earnings, with some intermittent stalls and decreases. However, the bid for those calls remained constant, more or less single-handedly taking volatility in Oct from 58 to 75. Many traders were calculating different standard deviation moves and falling over each other to strap on ratio call spreads. Keep in mind as early as 9 months ago, the VIX was in the teens, most earnings were meeting or exceeding with small 5-9% (at most) increases the next day. With the droning of the current environment front-most in their minds, most of the trading populace was playing for (maybe) a 10-15% move at most. This was evident from the at-the-money straddle price of around $14. Needless to say, it moved more than that. The AMZN was a good example of losing track of order flow and being hoodwinked by current market conditions.

Another way to gauge order flow is to keep abreast of the open interest of classes. If there seems to be a “terminator” buyer of stock ABC 30 calls with 0 open interest on that line and stock trading $26, that would be a primary indication to “run for the hills”. As a floor trader, being the first line of defense, I would sell my minimum amount obligated and move the market aggressively up, as well as be aggressive on my hedge (instead of buying stock delta neutral, I might consider buying stock closer to 1:1).

On the flip side, keep in mind if the buyer of these calls is complete, and the stock does not run up or get taken over quickly. If some sellers of options start to come into the marketplace, this is an initial sign to bring implied volatility back to its norm. After the first bid of mine would get hit, I would lower my levels accordingly. If the buyer of these options is looking to get out of his or her position, I would aggressively lower volatility more and more so that I would buy the calls back in at a much lower implied volatility (also not forgetting to sell out of my long stock!). This is a good example of how order flow can be the “accordion player” of the option markets, expanding implied volatility by putting a lot of air (premium) in the markets then bring things right back home to rest. Reading paper flow is an art not a science, when done correctly; the “accordion” is the best sounding musical instrument a trader plays!