Traders use different technical indicators to make trading decisions depending on the chosen strategy and trading style. This article looks at some of the best technical indicators for options trading. It also focuses on calculations related to technical indicators. But first, let’s get acquainted with the terminology of options.
What is options trading?
The basic concept of options trading is simple: one can buy an option contract from someone who already owns one or more contracts. In the case of call options, one has the right (but not the obligation) to buy shares at a set price by a particular date in the future.
The holding period of options is paramount to a trader as they are subject to time decay.
The option has an expiration date to which the trader is limited. But a stock trader can hold a position indefinitely. Therefore, options traders often use momentum indicators to determine overbought and oversold levels.
Let’s find out what are the best technical indicators for options trading.
Relative Strength Index (RSI)
The Relative Strength Indicator (RSI) is one of the top indicators for options trading that helps traders analyze price trends. It can be used to determine when security is overbought or oversold and spot potential turning points in price movement. It works by comparing the security’s recent price movement to prior movement to determine the momentum of the price fluctuation.
The RSI has two main signals: overbought and oversold. When an asset is overbought, the market is too optimistic about its future performance. When an asset is oversold, the market is too pessimistic about its future performance.
The RSI uses a series of bars to calculate a value between 0 and 100. A high RSI, generally above 70, indicates overbought levels. The price of a given security will likely rise over time because investors believe it will outperform other securities in the same category. A low RSI, typically below 30, indicates oversold levels and that investors expect the price of a given security to decline over time.
Technical analysts typically use the RSI indicator on trading options on stocks rather than indexes. High-beta stocks generally exhibit a volatile RSI value that touches overbought and oversold conditions more often than indexes, making it an effective indicator for short-term trading.
Bollinger bands are one of the best technical indicators for options trading to measure the volatility in the price action. The width of the Bollinger bands illustrates the volatility; as the volatility of the security’s price increases, the bands expand, and as the volatility of the security’s price decreases, the band contracts. This indicator is built off a moving average and can determine if an asset is overbought or oversold over a period.
As the price of an asset approaches the upper band, the market takes an interest in permitting the price to follow the bullish trend. Contrary, a price movement toward the lower band suggests that a bearish trend will follow.
This is one of the best trading indicators for options that allow traders to take advantage of market volatility by closing, observing the trends, and breakout opportunities. Price fluctuation outside the bands can signal a reversal in price momentum. A price move outside the bands can signal that the security is ripe for a reversal, and options traders can position themselves accordingly. For instance, the trader may initiate a long put or a short call position after a breakout above the top band and vice versa.
Intraday Momentum Index (IMI)
The Intraday Momentum Index is undoubtedly one of the best indicators for day trading options. IMI generates signals by combining certain aspects of RSI and candlestick analysis. It analyzes the correlation of opening and closing prices during the 1-day timeframe rather than the variation between days. This allows the traders to predict when the security is overbought or oversold during an intra-day trading session.
The calculation of IMI is straightforward; it looks at the relationship between “up closes”, i.e., the closing price is greater than the opening price, and “down closes”, i.e., the opening price is greater than the closing price. It is the proportion of gains on “up closes” over the total gains and losses on up and down closes over a period “n”. The value of “n” is generally taken as 14 days.
The value of IMI can be interpreted just like the RSI; if the value is above or equivalent to 70, the security is overbought and can be anticipated to go up. And if the value of IMI is below 30, the market is overselling, and the price can observe a downtrend.
Note! The intraday indicators are typically considered more beneficial for trading in the short term instead of the long term.
Money Flow Index (MFI)
The Money Flow Index (MFI) is one of the best options trading indicators that helps traders generate overbought and oversold signals. It takes into account price and trading volume data for a particular security. The analysis of IMI is coherent with the relative strength index; hence it is often denoted as volume-weighted RSI.
The MFI reading oscillates between 0 and 100. The higher an asset’s MFI, the more active it appears to be and, therefore, the greater demand for a position. A high MFI above 80 indicates strong buying interest, and a low MFI below 20 indicates strong selling interest. Interestingly, the MFI value can exhibit divergence, i.e., movement of MIF opposite to the price direction. This divergence typically suggests a reversal in the price trend, and traders watch these divergences for potential trading opportunities, making it one of the reliable indicators for binary options trading.
Put-Call Ratio (PCR) Indicator
The put and call option gives the buyer the right to sell or buy an asset at the strike price respectively before the expiration date. The put-call ratio is a formula that helps to determine whether an asset is overbought or oversold based on the relationship between put options and call options. When more put options than call options are available for trading, PCR is greater than 1, signaling a bearish trend. Contrary, when there are more call options than put options, the ratio is less than 1, and the investors expect a price rise, which signals a bullish pull.
PCR indicator for options trading provides a good evaluation of overall market sentiment; hence it can also be used in contrarian investing strategy. The trader looks for extreme put-call ratio values, which indicate a strong bullish or bearish trend; then, a trader might want to invest against market sentiment. These signals are valid because the undue bullish pulls and bearish signals do not last long enough and are subject to reversal.
Open Interest (OI)
Open interest is a measurement of the total number of outstanding open contracts that still need to be settled. It is one of the best chart indicators for options trading, representing the capital flow in and out of the market. Open interest, as its name suggests, indicates open positions that still need to be closed, expired, or settled. A high level of open interest can demonstrate that more contracts are open than the number of closed positions. This means that traders closely analyze the asset, which has significant potential for volatility in price movement.
Open interest portrays the market’s interest in the sustainability of the ongoing trend. A similar trend of price movement and OI values can be interpreted as a positive indication for the continuation of the trend. For instance, a rising price trend and a rising OI value suggest that there is an inflow of capital into an asset, and it will continue its uprising trend.
Let’s look at a few questions about options trading.
Can I place limit orders on options?
Yes, you can place a limit order. The order will be complete when options contracts are available at your specified price. On the other hand, you can also place a market order to be filled immediately at the market price.
What determines the price of an option?
The price of options trades can be determined by five parameters: current price, strike price, expiration date, interest rate, and asset volatility.
What are the risk measures used with options?
Traders typically monitor five Greek risk measures to analyze option risks. These include Delta, Gamma, Vega, Theta, and Rho.
The bottom line
The options trading indicators discussed in this article are all essential to know as an options trader, but their usefulness is determined by trading techniques. Also, it is crucial to understand their limitations and how experienced traders use them. Which indicators are best for options trading depends upon the trading strategy and style. To be profitable, research the merits of each and decide which indicators are best for your options trading.