Premium Flow with Z Scores

Introduction

Premium flow analysis tracks the amount of money (premium) spent on options contracts. By applying statistical techniques like z scores, traders can identify unusual activity and potential trading opportunities. This approach is popular among quant traders for spotting large, outlier trades that may signal institutional moves or market sentiment shifts.

What is Premium Flow?

Premium flow refers to the total dollar amount paid for options contracts, often aggregated by ticker, strike, or expiration. High premium flow can indicate strong interest or conviction in a particular option.

Why Use Z Scores?

A z score standardizes premium flow by comparing current activity to its historical average and volatility. This helps traders quickly spot when premium flow is unusually high or low compared to normal levels.

Formula for Z Score

The z score for premium flow is calculated as:

Z = \frac{X - \mu}{\sigma}

Where:

$X$ = Current premium flow
$\mu$ = Mean (average) premium flow over a lookback period
$\sigma$ = Standard deviation of premium flow over the same period

A high positive z score means current premium flow is much higher than usual; a negative z score means it's much lower.

How Traders Use Premium Flow with Z Scores

Unusual Options Activity: Spotting spikes in premium flow can reveal large trades or shifts in sentiment.
Filtering Noise: Z scores help filter out normal fluctuations and focus on statistically significant moves.
Strategy Development: Quant traders may build signals or alerts based on premium flow z scores to time entries or exits.

Example

Suppose the average daily premium flow for a stock is $1M with a standard deviation of$ 200K. If today's premium flow is $1.5M:

Z = \frac{1,500,000 - 1,000,000}{200,000} = 2.5

A z score of 2.5 suggests today's premium flow is 2.5 standard deviations above the mean—potentially worth investigating.

Conclusion

Premium flow with z scores is a powerful tool for quant traders to detect unusual options activity and inform trading decisions. By combining statistical rigor with market data, traders can gain an edge in identifying opportunities and managing risk.