Options traders need to get the market’s direction right more often than not to execute trades that bring in a profit. Identifying market trends is the key to determining possible price direction or market sentiment, and using options flow data is instrumental in helping traders spot bullish and bearish divergences. Options flow provides insights into where money is being invested as it traces the movement of large volumes of options contracts.
Bullish and bearish divergences in the context of options flow are instances where the moves of institutional traders aren’t matching with current prices and market direction, which could suggest that uptrends or downtrends are about to reverse. Our guide will focus on how to use options flow data to spot these divergences between what smart money is doing and what individual traders are doing to keep ahead of market reversals.
Understanding Options Flow
Options flow is the tracking of large options traders made by “smart money” (institutional traders and market movers), which reveals where the significant money is being traded within the wider options market. As options flow shows where the big money is going, traders can get potential market insights, and they can predict future price movements within the market correctly. Options flow tools let traders view the primary aspects of large options orders like strike prices, expiration dates, and volume.
Understanding options flow includes knowing the difference between institutional and retail options flow. We’ve already discussed institutional options flow, so retail options flow represents the trading activity of individual traders or investors that focus on less market influence and smaller trade sizes. If you’re an individual trader, learning how to read options flow will let you navigate institutional order flow with the best of them.
What Are Bullish and Bearish Divergences?
Divergences in options trading often signal potential reversals or continuations of current market trends. It’s key for traders to have a good understanding of bullish and bearish divergences to have a good gauge of when to keep riding the trends or to prepare for those trends to reverse. These trading tools can give traders the foresight they need to prepare their action plans with the ever-changing market conditions.
Define Bullish Divergence
This refers to a technical analysis indicator that occurs when an asset’s price falls, but a technical indicator is rising. Bullish divergence indicates that a current downtrend could be losing steam and is soon to reverse course. Simply put, it’s when the price of an asset is falling or consolidating while options flow shows bullish activity.
Define Bearish Divergence
Bullish divergence is a technical analysis indicator like bullish divergence, but in this case, it refers to a scenario where an asset’s price is increasing, but the related indicator is going in the other direction. It signals an uptrend is about to end, and a downtrend is soon to take its place. Bullish divergence has the price of an asset rising or consolidating while options flow shows bearish activity.
Bullish and bearish indicators not only give traders a good idea of possible market direction but also the speed at which the current trends will continue or reverse.
How to Identify Bullish Divergences Using Options Flow
Traders can pinpoint bullish divergences using options flow. These are the signs that the market is soon to be coming out of a downtrend and that an uptrend in the other direction is soon to begin. There are three major signs that traders will want to look out for, which we’ll address with the following key indicators.
Key Indicators of Bullish Divergence
- Increased Call Option Volume: To be clear, bullish divergence is made evident when the higher volume of call options occurs while the asset price is declining. This is referred to as “indicator discrepancy,” where there’s a mismatch between the price direction and the momentum indicator.
- Higher Open Interest in Call Options: Call options will have higher open interest compared to puts, which indicates stronger bullish sentiment in the market. It means that more traders are betting on the rise of underlying assets, which triggers traders to buy more call options than put options. As open interest indicates the total number of outstanding options contracts, the higher open interest shows that traders are taking on actively bullish positions.
- Large Bullish Trades by Institutional Traders: You can usually tell where the market is about to go if you keep a close eye on the moves that smart money is making. If you’re seeing a lot of bullish activity by the market makers, that’s a great sign that bullish divergence is occurring (the downtrend is about to reverse course into an uptrend).
Case Example of a Bullish Divergence
The stock price is declining, which creates a series of lower lows on the charts. For this scenario, let’s say the stock drops from $90 to $85 to $80. At the same time, the Relative Strength Indicator is showing the trader higher lows. For the sake of the example, let’s say that RSI goes from 20 to 22 to 25. What does it all mean?
This is a signal that the momentum behind the decline is slacking off and that an uptrend is imminent. This bullish divergence shows that the selling pressure might be decreasing and that a price reversal could possibly occur at some point in the near future. Something to keep in mind is that the bullish divergence isn’t always a guaranteed signal to buy, so traders need to think about other technical indicators and market analysis for ultimately confirmation of a trend continuation or reversal.
Tools to Track Options Flow
- FlowAlgo: A financial data algorithm that analyzes and tracks the stock and options markets and their respective transactions. It’s a great tool for getting real-time order flow data. FlowAlgo analyzes all time and sales, pinpoints all smart money transactions (using data like size, volume, order types, etc.), and uses alerts to keep traders in the know on market-moving orders in real-time.
- Unusual Whales: A financial data app/website that gives traders the right tools to track all unusual transactions and trading activity within the stock and options markets. Unusual Whales offers traders real-time and historical data, live charting tools, news feeds, options profit calculators, and alerts for unusual activity with stocks and options.
- Cheddar Flow: This platform provides traders with real-time data on options activity in the stock and options markets within the United States. Cheddar Flow users can get AI-powered signals to spot potential trend reversals or continuations, customizable filters to find trading setups, desktop alerts, and real-time options flow data.
How to Identify Bearish Divergences Using Options Flow
Now, let’s talk about how traders can spot bear divergences using options flow data. We’ll discuss the most important key indicators that are signaling a current market uptrend is about to reverse and become a downtrend.
Key Indicators of Bearish Divergence
- Increased Put Option Volume: Traders will want to see this while the asset price is rising at the same time. Like the key indicators of bullish divergence, this is another example of an indicator discrepancy where there’s a mismatch between the price direction and the momentum indicator.
- Higher Open Interest in Put Options: Put options will have higher open interest compared to calls, which indicates a stronger bearish sentiment in the market. It means that more traders are betting on the fall of underlying assets, which triggers traders to buy more put options than call options. As open interest indicates the total number of outstanding options contracts, the higher open interest shows that traders are taking on bearish positions.
- Large Bearish Trades by Institutional Traders: Just as bullish divergence can be detected when looking at the moves the market makers are executing, you can do the same with bearish divergence. If the smart money institutional traders are taking up a lot more large bearish trades, it’s a good sign that they’re preparing for an uptrend to lose steam and be replaced with a downtrend.
Case Example of a Bearish Divergence
Our case example will take the scenario we set up when talking about bullish divergence, and we’ll simply reverse it. In this example, the stock price is increasing, which creates a series of higher highs on the charts. The stock has risen from $80 to $85 to $90. At the same time, the Relative Strength Indicator is forming lower highs. RSI goes from 25 to 22 to 20.
The signal that this phenomenon is setting off is that the current momentum behind the stock price increase is waning and that a bearish downtrend is due to set in. This bearish divergence shows that the buying pressure might be decreasing and that a price reversal could occur at some point shortly.
Don’t use bearish divergence signals found with options flow data in complete isolation. It’s best to use other market analysis tools and technical indicators in conjunction with options flow data to get the most accurate reading on the situation. Refer to platforms like FlowAlgo, Unusual Whales, and Cheddar Flow for the tools you need to properly identify bearish divergence and confirm that the prediction is valid.
Practical Steps to Use Options Flow for Bullish and Bearish Divergences
To take those first few practical steps toward working options flow data into your trading sessions to spot bullish and bearish divergences, check out our step-by-step guide for getting started and some of the best, practical tips for using these tools. It doesn’t matter if you’re new or you have a lot of background experience—we’ve included plenty of tips for newbies and seasoned vets alike.
Step-by-Step Guide
Follow these step-by-step instructions to get started with using options flow data for pinpointing possible market trend continuations or reversals.
- Choose a Reliable Options Flow Platform: Select a reputable options flow website or mobile app so you can get options flow data in real time. There are dedicated platforms, which we’ve already mentioned, like Cheddar Flow, FlowAlgo, and Unusual Whales. Plus, some online broker apps feature real-time options flow data, such as Robinhood and Tastytrade.
- Identify Unusual Options Activity that Contradicts Current Price Action: The idea behind spotting bullish and bearish divergences is to find places in the data where smart money is going against the current market trend. There are a few other ways to spot divergences, like increased volume or open interest.
- Analyze Volume, Open Interest, and Trade Size: To gauge divergence strength, look into these other aspects of the current trading patterns using other market analysis tools and technical indicators. Using options flow data to spot bullish and bearish divergences and then backing it up with these other indicators is your ticket to correctly predicting the market direction and sentiment.
- Confirm with Technical Indicators: As we said, pairing options flow with other indicators is the way to form the most complete picture of what’s occurring in the market. Use tools like the Relative Strength Index, Moving Averages Convergence Divergence, and traditional moving averages to cross-check everything before buying or selling positions.
- Assess Risk and Reward: Before placing your trades, outline the best possible scenario when it comes to securing a profit and the worst-case scenario involving the capital you’re putting at risk. Analyzing these two scenarios gives you an idea of a range of possible outcomes. Use this data to gauge if certain trades will be worth your time or not.
Tips for Beginners and Advanced Traders
The following tips and tricks for dealing with options flow data in finding bullish and bearish divergences work well for both beginners and advanced traders. Many of these principles and best practices are timeless, so any trader from any skill level or background reading these tips can learn some new things or get refreshed in their knowledge of using option flow data.
Observation
Take some time to learn how options flow works if you’re newer to trading. By observing the market without putting any of your money on the line, you can understand options flow and find trading techniques that work best for your trading style.
Understanding Why
In observing smart money order flow, it’s key to ask why institutional traders are buying and to cross-check theories with recent market news.
Cross Check Options Flow with Other Indicators
It’s key for any trader to not blindly trade based on institutional traders’ moves but to use other technical and market analyses to back up these theories. Use tools like dark pool activity or news sentiment to support theories you might have potential trend continuations or reversals.
Use Trade Tickets to Your Advantage
These can be a helpful tool because there are times when tickers show consensus on the part of most institutional traders. What this means is that these smart money traders are in agreement on a market direction, and there’s no broader strategy behind the consensus. This means that individual traders can use tickers with close to 100% bullish or bearish flow as a good guarantee of where the market is heading.
Avoid Trading Earnings or News Jumps
If you’re someone who isn’t interested in trading volatility, it’s best to avoid trading around earnings announcements or significant news events. Often, stock prices can have a knee-jerk reaction to news like this, so it’s best to wait and not act on these opportunities immediately to get a firm idea of which direction the market might be going.
Pay Attention to Small Orders
If you begin seeing smaller orders being placed by the smart money traders that are pointing in a particular direction, it can be a good sign that larger orders will start pouring in once the smart money traders have gained confidence in the new direction through their more advanced researching techniques. Keep an eye on how the small orders are trending to get a gauge of whether or not larger orders will follow in short order.
Look For New Flow
Avoid chasing trades that have been run up for weeks. Look for opportunities where the flow has changed direction or you’re seeing new flow completely. The best opportunities are usually the ones where puts begin coming in after large bull runs.
Use Good Risk Management Practices
In addition to using a more conservative position size, setting up stop-loss orders, and having clearly defined entries and exits in your trades, you should consider de-risking your trades with having longer expirations, trading them closer to the money, and using multi-leg strategies. It’s also preferable to use stocks instead of options.
Common Mistakes to Avoid
What are some of the biggest mistakes or blunders that options traders could make when using options flow to spot bullish and bearish divergences? That’s exactly what we’ll address here as we talk about the ways that you can keep from making these common mistakes that so many other traders have in the past without knowing it.
- Misinterpreting Short-Term Fluctuations as Divergences: Some traders make the mistake of thinking that short-term fluctuations are the divergences that happen when smart money trades don’t match the current market direction. Because financial markets move in cycles, there are bound to be small fluctuations in the numbers that are driven by supply and demand, macroeconomic trends, and trader sentiment. Don’t confuse small fluctuations with divergence.
- Ignoring Broader Market Trends and Catalysts: Traders need to make a concerted effort to pay attention to broader market trends and catalysts like major news events or companies releasing their earnings reports. These occurrences go a long way toward informing traders that they are going to see a continuation of the current trend or a reversal altogether.
- Over-Relying on Options Flow: As we’ve mentioned a few times throughout this guide, using options flow in isolation without using any other technical or fundamental confirmation is a good way to get your prediction wrong and to make the wrong trade move. Options flow isn’t a guarantee, but it’s a puzzle piece of the greater picture of what’s happening.
- Using Incomplete or Inaccurate Data From Unreliable Sources: Using subpar data to inform your trading strategy is another way that traders can get the future market direction or the sentiment of other traders completely wrong. This is why we emphasized using reputable and reliable options flow platforms to get the best data to inform your strategy.
Advantages of Using Options Flow to Spot Bullish and Bearish Divergences
What are the best perks and benefits for traders who look for bearish or bullish divergences using options flow data? We’ll address the greatest advantages that traders will experience when using reputable and reliable options flow platforms for gauging market direction and potential price movements.
- Real-Time Insights into Institutional Sentiment: A significant perk of options flow and its ability to detect bullish and bearish divergences between smart money moves and what’s currently happening in the market. Traders can gain real-time insights into what direction the institutional traders feel the market is heading. You can use the live data to stay on top of possible market sentiment. The timely updates can help retail traders pivot from one strategy to the next if the market sentiment changes at the last minute.
- Leading Indicator for Potential Price Movements: Using options flow to find bullish and bearish divergences in the market lets traders get insights into where the price will potentially move. Just as you can get real-time insights into where the smart money believes the market will move, you can use options flow as a key indicator of the price movement as well. This includes not only the direction of the price movement but the magnitude of the movement as well.
- Enhanced Confidence in Trade Decisions with Data-Backed Signals: The more that traders can use options flow data in conjunction with other technical indicators, the more confidence they can build in making future trading decisions. Traders can follow the moves of institutional traders and do so knowing that their trades are data-backed with options flow and other technical indicators.
Spot Bullish and Bearish Divergences Easily with Options Flow
While divergences aren’t always a complete indicator that a trend reversal is coming up, traders can get a complete picture of what’s going on by using option flow data to find out what the market makers are doing and finding ways to profit from what they are telegraphing about the possible future price direction and market sentiment.
Spotting bullish and bearish divergences using options flow is useful when trying to figure out if a current uptrend or downtrend is going to continue as normal or if it’s going to reverse. There’s a great competitive advantage that traders hold when using options flow to anticipate market moves—the tools let them keep one step ahead of other individual traders and get key insights into where the market might be moving next and by how much.
If you haven’t worked options flow data into your trading regimen, we’d encourage you to start practicing with reliable options flow platforms for better trade outcomes. Check out apps or websites such as Cheddar Flow, Unusual Whales, and FlowAlgo for the best results!
Frequently Asked Questions
In case there was anything that we might have missed or glossed over while discussing options flow and pinpointing bullish and bearish divergences, we’ll address it here, where we’ve featured some of the most common questions from our customers and readers on the subject.
What Is the Difference between Options Flow and Options Volume?
Options volume refers to the total number of contracts traded during a specific period, while options flow refers to analyzing the movement of large volumes of options contracts. Options flow is a deeper analysis of volume data where traders can get insights into market direction and other traders’ sentiments. Options flow also highlights where smart money (institutional traders) is flowing within the options market as a whole.
Can Retail Traders Rely on Options Flow as a Primary Indicator?
It’s never a good move to use options flow in isolation without other technical indicators or market analysis tools to back up theories on possible market direction or sentiment. While traders can use options flow as their primary indicator, it’s best not to use it as the sole indicator. Using it without backup from other technical indicators can result in traders misreading the market entirely. Traders have to look at the entire picture.
How Often Do Bullish or Bearish Divergences Result in a Price Reversal?
While bullish and bearish divergences can be a strong signal or warning sign that a reversal is about to take place, it’s not always a guarantee. There are times when traders might see divergences, but a reversal doesn’t happen. Instead, the result might be a trend slowdown or a consolidation phase. All of that said, trend reversals that are preceded by divergences are pretty infrequent. This is why it’s so important that traders take the time to cross-check everything with other market analysis tools and technical indications.
Are There Free Tools Available to Track Options Flow?
There aren’t too many free options flow platforms out in the market, and not any that allow users full functionality anyway. Cacoo is a free user flow tool with limited features, FlowMapp is a free user flow diagramming tool, and InsiderFinance comes with limited free data. You’ll be hard-pressed to find a platform that provides all of these important services completely free of charge.
How Can Beginners Start Using Options Flow without Risking Too Much Capital?
Newer traders can pull this off in a few different ways. Focusing on a smaller position size lets traders test the waters of trading using options flow tools without putting too much capital at stake. There’s also the route of using sound risk management strategies where traders set up stop-loss orders to keep their losses from getting too out of hand. Some trading apps have paper trading simulators and demo accounts where traders can practice strategies and techniques with a virtual balance without risking their capital.
