Did you know institutional traders account for over 70% of options market volume? Their moves can make or break your trades.
Understanding institutional influence is critical for retail traders to succeed when dealing with online options. Some traders refer to this type of trading as “smart money” while others call it institutional trading. Though these kinds of traders are referred to by different names, they all are professional traders who work for large financial institutions like pension funds, hedge funds, or banks. The moves of these large investors can create ripple effects in the market when it comes to factors like pricing, volatility, and liquidity.
Our guide will explain how institutional traders shape the options market and actionable ways to identify their activity. Keep reading to learn about how smart money can influence the market, the tools and indicators needed for retail traders to spot institutional activity, and some practical strategies for dealing with these matters when they occur.
Who Are Institutional Traders?
Institutional traders are professional investors who buy and sell financial assets on behalf of large financial institutions including hedge funds, banks, proprietary trading firms, or pension funds. Because these traders have access to high-end resources like large sums of capital, access to exclusive data, and advanced algorithms, their trading habits can have a significant impact on market liquidity and option prices. Institutional traders’s actions can result in market-wide shifts which also affect the level of volatility felt by retail traders.
Scale of Influence
How do institutional traders operate? In addition to the resources they have at their disposal (billions in capital, advanced algorithms, and access to exclusive data), they use advanced trading techniques, diversify their investments across multiple asset classes, make long-term investments, prioritize risk management, and use the best in technical and fundamental analysis.
Role in Options Markets
Institutional traders play a dual role as liquidity providers and market movers in the options market. Due to their access to more advanced data sets and greater capital, institutional investors can have a significant role in how events play out in the options market, often involving price fluctuations, the direction of the marker, and how easy it is for traders to enter or exit certain stock positions.
- Liquidity Provider: Large financial institutions actively participate in markets by buying and selling assets at quoted prices simultaneously. This ultimately ensures that there’s a readily available supply to make smooth trading possible (quick/easy entries and exits) and to minimize price volatility for retail traders. The market becomes much more liquid by their presence where they are constantly offering bids and asks.
- Market Movers: These entities can significantly influence market prices by buying and selling large amounts of securities. This lets them dictate the market direction as their large trades can create significant shifts in the supply and demand dynamics of a market. Their actions eventually lead to price fluctuations for other investors and traders.
Why It Matters
Institutional investors’ actions ripple through pricing, volatility, and retail trader opportunities. What they do matters to retail traders because a lot of the market conditions that smaller traders have to deal with can be linked back to what the institutional traders and market makers are doing.
- Pricing: Making large-volume trades the way that institutional investors do has a profound effect on pricing. It can cause noticeable price movements in securities in more liquid markets. The sheer size of the transactions that are carried out by institutional traders where there’s increased buying and selling activity can have a major effect on the pricing of options.
- Volatility: These traders can impact market volatility by making large simultaneous trades, which can cause sudden price swings. This can affect short-term volatility, especially. On the other hand, institutional traders can have a stabilized effect on the market by increasing liquidity and counteracting extreme price fluctuations.
- Trading Opportunities: Institutional traders can drive market movements because of the large trading volume they engage in—it influences trends and creates price volatility. In turn, this can create some difficulties for retail investors as they will have to correctly navigate the market and determine possible market direction as best they can. Retail traders also need to find the best entry and exit points for their investments amid the market markers’ moves.
How Institutional Traders Influence Options Markets
It’s safe to say that the moves of institutional traders can have a significant impact on the options market, from making contracts more liquid due to the trading volume involved with their large transactions to influencing the volatility conditions of the market when their traders cause price swings to occur. Keep reading to learn how these things are possible with the money makers and institutional traders having a considerable influence on market sentiment.
Large-Scale Options Buying and Selling
Massive trades like block trades impact underlying stock prices and options premiums. The large volume of business conducted by large, market-moving forces can cause noticeable price movements when large quantities are bought and sold, often simultaneously. This can have a profound influence on market sentiment, which leads to options pricing being impacted as well.
Example
A hedge fund buying thousands of call options to hedge a position can have a great effect on the market. It puts upward pressure on the price of the underlying security due to the increased demand for call options driving up the price. If the hedge fund is buying up a considerable number of options relative to the overall trading volume, it could influence the price of the stock itself. Another result of this market-making move is that it could encourage other investors to buy the stock—it’s a move that gives off a bullish signal to retail traders.
Gamma Squeezes and Delta Hedging
Institutional buying of options forces market makers to hedge, amplifying price movements. You see this with market makers who create gamma squeezes when they’re attempting to maintain delta hedges with their investments by buying and selling the underlying asset. They make large purchases in an attempt to deal with a rapidly changing delta value. This can have a significant impact on the market—keep reading to get a better idea of gamma squeezes and delta hedging as well as how they’re related.
- Gamma and Gamma Squeezes: The metric that is used to measure how the delta of an option changes about the price of the underlying asset. Gamma squeezes are characterized by a sudden increase in the stock’s price, which happens when institutional investors and market makers buy large numbers of shares to cover their options positions. When this happens, a cycle of rising prices and more buying ensues, which could eventually lead to a considerable price spike.
- Delta and Delta Hedging: The metric that is used to measure how much an option’s price changes for every $1 change in the price of the underlying asset. Delta hedging is a strategy that exercises risk management by using options to reduce the risk of price changes within an asset. Market makers can achieve a “delta neutral” portfolio by calculating the delta of the portfolio, adjusting the positions to offset delta risk, and continually rebalancing the position to maintain delta neutrality as the market conditions change.
Real-World Example
The GameStop gamma squeeze of 2021 is a prime example of gamma squeezes occurring from delta hedging by market-making investors. This event was where a dramatic spike in the stock price of GameStop occurred and it was primarily driven by a buying spree on social media platforms, the most notable being Reddit.
Retail investors were attempting to implement a short squeeze by buying up a large amount of the GameStop stock. The result was that the price soared against the bets of large institutional investors and market makers. Since these investors had shorted the company heavily, anticipating the price to drop off, many short sellers incurred major losses because they were forced to buy back their shares at a higher price to cover themselves. This occurrence has the additional ripple effect of further driving up the price of the GameStop stock.
Volatility Manipulation
Another way that institutional traders can influence the options market is by suppressing or inflating implied volatility. It’s important to note that their impact has largely to do with the market conditions and the trading strategy they’re using. These market makers aren’t always intentionally trying to suppress or inflate IV, so much as they are simply making the best financial decisions for themselves.
Suppressing IV
– Call-Overwriting ETFs: Market makers are forced to buy when the market sells off and sell when the market rallies when these kinds of ETFs sell options to market makers. This results in decreased volatility as well as suppression of market moves.
– Option Selling Funds: Another significant way that institutional investors can suppress volatility is through option selling funds, which can contribute to structural dislocation, which ultimately suppresses implied volatility in the market.
– Short Volatility Strategies: When market makers implement these types of strategies where they sell equity options or take short positions on VIX-based derivatives, this can lead to the suppression of implied volatility. Traders can still generate a profit from low volatility, but they lose money if volatility spikes upward.
Inflating IV
– Herd Mentality: Implied volatility can become inflated when multiple institutional investors react in a similar way to market news or events. This causes the price swings to get even more pronounced as a ton of investors are trying to buy and sell all at once.
– Market Timing Strategies: Increased volatility can occur when market makers try to anticipate market movements by quickly buying and selling based on short-term market signals.
– Market Power: Due to their ability to move large amounts of capital around quickly, institutional investors can create noticeable price fluctuations as they enter and exit positions within the market.
– Trading With Algorithms: When institutional investors use complex trading algorithms to execute their investment strategies, the rapid movements can create sudden bursts of buying and selling, which could worsen market volatility.
When it comes to volatility manipulation by market makers, there are some connections between VIX and market sentiment. The connection between manipulation and VIX where the mechanics of VIX could allow for manipulation by market makers when they strategically trade options that influence its calculation. This can lead to artificially deflated or inflated volatility readings.
There is a much stronger connection between volatility manipulation and market sentiment, however, where manipulation of market volatility can lead to heightened market uncertainty or increased price fluctuations. Increased volatility can lead to emotional trading decisions like fear, overconfidence, or greed. This could lead to increased buying and selling that’s based on market sentiment rather than technical or fundamental analysis.
Pinning and Expiration Plays
Institutional inventors can also impact the options market when securities close at or near the strike price of heavily traded options. This is known in trading as “pinning” and stock prices tend to pin the strike when the option is almost in the money and there’s significant open interest. These stocks ultimately gravitate toward strike prices near expiration due to institutional hedging.
It’s believed that market markets and institutional traders might influence an asset’s price to align with the max pain point (when options are out of the money at expiration and they expire as worthless). Many institutional traders do this in an attempt to maximize their potential profits.
Tools and Indicators to Spot Institutional Moves
To pinpoint the moves of institutional investors and the primary market makers, you’ll want to use the best tools and indicators possible to detect this activity quickly and then act on it to stay a few steps ahead of everyone else! Some notable tools and indicators that are “must haves” in these situations are unusual options activity indicators, order flow data, open interest/volume analysis tools, price action indicators, and tools that gauge support or resistance levels.
Unusual Options Activity (UOA)
Unusual options activity is where there’s a considerable increase in trading for a stock’s options. UOA can indicate that a large trader is being made by institutional investors or market makers. It’s an indicator that is a clear red flag for institutional activity.
Retail traders and investors can access UOA data on their trading app or investment website of choice. These are helpful tools that outline all the relevant information needed to spot unusual options activity, including open interest, volume, or implied volatility for each strike price.
TradeStation: Open the “Options Chain” to navigate the security you want to add to your chart. Analyze the key data points like open interest, volume, and implied volatility for each strike price to discover the main deviations from the typical trading patterns. You can then use the filtering option to focus on the strike prices or timeframes you’re interested in, along with any applicable data on open interest, volume, or price changes.
Thinkorswim: Select the “Scan” tab and then select “Stock Hacker.” Once you locate the “Sizzle Index,” you can begin looking for stocks with highly unusual option activity. You can scan the criteria to filter for specific volumes, market cap thresholds, and prices.
A good example of unusual options activity would be when a sudden spike in call volume on a stock occurs with no obvious news. Traders who know what to look for can deduce that this could be institutional money at work anticipating a potential upward breakout that retail traders simply aren’t seeing, be it for a lack of research or access to more advanced data sets. Of course, to get the best reading on the situation as possible, pair this assumption with other technical indicators to see if it’s accurate.
Open Interest and Volume Analysis
Two other important technical indicators for spotting unusual options activity are volume and open interest. There’s a big difference between the two, but they’re closely linked.
- Volume indicates the amount of an asset or security that changes hands over some time (usually during a single trading day). It’s the total number of shares or contracts that are bought or sold during that period, which measures the level of activity or liquidity in the market for that asset.
- Open interest refers to the number of outstanding contracts for a security that have yet to be settled. It’s calculated by adding all the open trades and subtracting them from the closing trades. Open interest indicates the overall level of market participation, differing from volume, which shows the amount of trading happening at any given moment.
To spot institutional footprints using volume and open interest together, it’s advised to look for large jumps in open interest at specific strikes. So many outstanding options contracts at a certain strike price indicate a sudden surge of market interest, which could be a bullish or bearish sign depending on if high open interest is concentrated in a call or put option.
- Bullish Sign: A rise in price along with an increase in open interest suggests growing buying pressure from the market makers.
- Bearish Sign: A fall in price along with a decrease in open interest suggests growing selling pressure from the market makers.
A few other good ways to spot UOA in open interest and volume data include looking for large volume spikes with price movement (a stock experiences a sudden increase in volume along with a noticeable price change), a sudden increase in open interest with minimal price movement, and when the price moves in one direction while the open interest moves in the opposite direction.
Order Flow Data
Order flow data is the real-time stream of buy and sell orders that traders (retail and institutional) place in the marketplace, which brings insights into the supply and demand. Traders can view the volume of orders at different price levels to anticipate price movements and gauge market sentiment to the best of their ability.
Order flow data provides important details that traders should know about, like the size of the orders, the availability of buy and sell orders, and the price at which these orders are placed. Investors or traders can analyze order flow data and pinpoint potential imbalances between buyers and sellers while also understanding the dynamics of the market more completely.
Good Order Flow Data Tools
- Cheddar Flow: A platform that focuses solely on options contracts and provides details about strike prices, volumes of options being traded, and expiration dates. It’s specifically designed for traders who want to detect unusual options activity by institutional traders by looking at significant buying or selling pressure which isn’t typical.
- BlackBoxStocks: This is a terrific options flow scanner that tracks the large purchases in specific options contracts to detect smart money moves in real time. Retail traders can use this tool to get a better sense of the options market direction and other aspects like price direction and track trades in dark pools.
An important consideration with order flow analysis is how to interpret big sweeps, block trades, or aggressive buying/selling. We’ll offer our key insights below on how to eye up these occurrences and what to make of them in the broader context of the market.
- Big Sweeps—A signal of potential strong market movement, which ultimately depends on the direction of the sweep. Sweeps that occur near the asking price suggest to traders that bullish sentiment is imminent. Sweeps near the bid price are a signal of bearish sentiment.
- Block Trades—If the block trades are all happening in the same direction for a particular stock, that can indicate strong sentiment with institutional traders. It’s key to view block traders in the context of the overall market and recent price movements in the underlying stock.
- Aggressive Buying and Selling—Aggressive buyers will place market orders to buy immediately, which results in the ask price being lifted. Prices need to be increased to the next available seller if all of the seller’s asks are filled. The bid price gets pushed down when aggressive sellers execute market orders to sell.
Price Action and Support/Resistance
Because institutional traders tend to sell at price points that align with previous support and resistance levels, their moves are more often connected to key technical levels on a chart. This can create notable price reactions at these points. These price reactions can be identified by technical analysis tools like volume profiles, trendlines, or Fibonacci retracements. Institutional traders’ large orders can act as a catalyst for price movements at these key levels.
Let’s run through a few other key factors that can bring you a bit more underlying to the connection between institutional traders and key technical levels:
- Volume: High volume at key price levels is a sign of institutional activity when large orders are executed. This can lead to considerable price movements.
- Order Flow: With the use of advanced charting tools, traders can see the size of orders and directions at different price levels. Traders can gain key insights into the potential buying or selling pressure created by institutional moves.
- Share Accumulation: Through gradual buying, institutional traders will accumulate shares within a certain price range which can lead to a consolidation phase that can be seen on the charts. Price breakdowns from a previous support level can occur when traders begin distributing shares.
It’s also important for retail traders to watch out for institutional moves at key levels, which can be done by looking for the following things:
- Price consolidation with high-volume
- Large candlestick patterns with high volume (can be bullish or bearish)
- Breakouts/breakdowns from support/resistance levels with high volume
Practical Strategies for Retail Traders
Let’s run through some of the most practical strategies for retail traders to navigate the options market and make the most of spotting the moves of market makers and institutional traders.
Follow the Smart Money
This refers to tracking the activity of institutional investors by analyzing multiple data sources like insider trading reports, volume analysis, market sentiment, and others. While following these smart money moves doesn’t always guarantee a profit, traders can effectively piggyback institutional trades without overcomplicating their strategy. It’s important, however, to avoid blindly chasing—verify with your analysis to be sure that you’re making the right move.
Timing Entries and Exits
Strategically enter or exit trades based on the anticipated actions of professional investors or large institutional traders. When you can identify trading patterns based on market behavior, this can allow you to profit from price movements that are influenced by large volume orders. Getting into and out of trades by riding the wave created by buying or selling pressure created by institutional traders is the key.
A good example of this would be to buy shares following the start of a gamma squeeze where there’s a cycle of rising price and more buying associated with an increase in the stock’s price which occurs when market makers buy large numbers of shares to cover their positions. Watch expiration dates to avoid getting caught in pinning.
Risk Management
Another form of online options trading you’re engaging in should always come with a risk management plan where you implement proper position sizing and the necessary stop-losses to mitigate potential risks. Use a position size of only 1-2% on any given position and have your money spread across multiple industries or sectors for diversification purposes. With stop-losses, place a limit on how much you’re willing to lose to keep your potential losses to a minimum.
Case Studies of Institutional Influence
Real-world examples or case studies of institutional traders and their influence on the market can give you a much better idea of how it could play out. We’ve provided some examples using Tesla for volatility plays in the present day and trading around historical events like the meme stock rally around GameStop in 2021.
Case Study 1—Tesla’s Popularity with Institutional Traders
Tesla is a great example of a stock with heavy institutional options activity, where they often see large volumes of options contracts traded. Because there’s a lot of market interest surrounding Tesla and there’s quite a bit of volatility surrounding its stock, this makes it one of the better choices for retail options traders to leverage institutional influence to their advantage.
A great amount of the Tesla stock is owned by institutional traders, which means that their actions have a considerable impact on the stock’s performance and movement. When these major traders buy or sell Tesla stock, it can send signals to the market, which ultimately influence trader’s decisions with other stocks in other market sectors.
Case Study 2—GameStop in 2021
GameStop’s stock had a gamma squeeze several years back, which led to a parabolic movement in the stock’s price. In 2021, many institutional traders had shorted GameStop stock because they thought its price would continue to fall. In the meantime, speculative retail traders bought a ton of call options on GameStop stock due to a coordinated effort to buy these shares, spearheaded on Reddit’s WallStreetBets. They believed that the stock was undervalued, and they wanted to take on Wall Street.
As the price of the GameStop stock rose due to a price surge of almost 1,625% in a single week, the market makers bought shares to hedge their positions, but they had to buy them back at a higher price. This higher share price led to more call buying, which created a feedback loop that forced market makers to buy even more shares.
The lessons learned from the short squeeze that the GameStop stock experienced illustrate not only the impact of social media on the stock market but also how market marker’s losses can have a ripple effect through the market. Following this incident, there was unprecedented market volatility, and some brokerages had to halt the buying of that stock, including platforms like Robinhood.
Track Smart Money and Back It Up with Other Technical Indicators
Retail traders can level the playing field by learning to spot the moves of institutional investors with the right tools and mindset. While tracking smart money in the options market can give retail traders a significant leg up, it’s key for them to also back up what they’re seeing with other technical indicators to be sure they’re seeing a clear trend and are reading the market correctly. Look into on-balance volume, MACD, the relative strength index, and others to get the right read on the situation.
Keep in Mind: That institutional traders drive options markets through scale, strategy, and sophistication. You can pinpoint many of these moves when you see occurrences like large-scale options buying or selling, gamma squeezes that are a result of delta hedging, and volatility manipulations by smart money traders.
For more information on options trading in general, explore all of our resources (e.g., tutorials, tools, or a newsletter) to deepen your options knowledge.
