Hundreds of technical indicators are available to traders, based on their trading style and the kind of investment being traded.
This article concentrates on a few key technical indicators used by options traders. Please keep in mind that this material presume knowledge of options language and the computations involved in technical indicators.
- The RSI scale runs from 0 to 100. Values more than 70 often indicate overbought levels, while values less than 30 suggest oversold levels.
- A price move outside of the Bollinger bands might indicate that an asset is about to revert, and options traders should position themselves appropriately.
- The intraday momentum index combines the principles of intraday candlesticks and RSI, displaying overbought and oversold levels and offering an appropriate range (similar to RSI) for intraday trading.
- A money flow index value of 80 or above suggests that an investment is overbought, while a score of 20 or below indicates that the asset is oversold.
- The put-call ratio gauges trade activity by comparing put options to call options, and changes in its value reflect a shift in market sentiment. The open interest indicator indicates the strength of a certain trend.
How Options Trading Is Different
Technical indicators are often employed in short-term trading to assist traders in determining:
- Range of movement (how much?)
- The movement’s direction (which way?)
- How long will the transfer take?
Because options are susceptible to temporal decay, the holding term is important. A stock trader may keep a position forever, but an option trader is restricted by the expiry date of the option. Because of the time limits, momentum indicators, which detect overbought and oversold levels, are popular among options traders.
Let’s take a look at several typical indicators utilized by options traders, such as momentum and others.
Relative Strength Index (RSI)
The relative strength index is a momentum indicator that compares the amount of recent gains to recent losses over a specific time period to detect overbought and oversold levels. RSI readings range from 0 to 100, with a number over 70 suggesting overbought levels and a value below 30 indicating oversold levels.
Because equities exhibit overbought and oversold levels more often than indexes, RSI works well for options on individual stocks rather than indexes. Based on RSI, options on highly liquid, high-beta equities are the best choices for short-term trading.
Volatility is important to all options traders, and Bollinger bands are a common approach to gauge volatility. The bands widen as volatility rises and constrict as volatility falls. The closer the price gets to the top band, the more overbought the security is, and the closer it gets to the lower band, the more oversold it is.
A price move outside of the bands might indicate that the security is about to revert, and options traders should position themselves appropriately. For example, after a breakthrough over the top band, a trader may begin a long put or a short call bet. A breakthrough below the bottom band, on the other hand, may provide an opportunity to deploy a long call or short put strategy.
Also, bear in mind that it frequently makes sense to sell options during times of high volatility, when option prices are high, and to purchase options during periods of low volatility, when option prices are low.
Intraday Momentum Index (IMI)
The Intraday Momentum Index is a useful technical indicator for high-frequency option traders interested in betting on intraday movements. It combines the principles of intraday candlesticks and RSI, offering a proper range for intraday trading (similar to RSI) by signaling overbought and oversold levels. Using IMI, an options trader may be able to identify prospective chances to enter a bullish trade in an up-trending market at an intraday price bump or a bearish trade in a down-trending market at an intraday price bump.
It is critical to be aware of the “trendiness” of price movements. Momentum indicators usually display overbought/oversold values when there is a strong evident rally or downturn.
To compute the IMI, divide the total number of up days by the total number of down days, or ISup (ISup + IS down), which is then multiplied by 100. While the trader has the option of selecting the number of days to examine, 14 days is the most frequent time period. If the final value is more than 70, the stock is termed overbought, much as the RSI. If the resultant figure is fewer than 30, the stock is thought to be oversold.
Money Flow Index (MFI)
The Money Flow Index is a momentum indicator that takes into account both price and volume data. Volume-weighted RSI is another name for it. The MFI indicator is an indication of “trading pressure” since it tracks the input and outflow of money into an asset over a certain time period (usually 14 days). A number more than 80 suggests that a security has been overbought, while a value less than 20 indicates that the asset has been oversold.
MFI is more suited to stock-based options trading (rather than index-based) and longer-duration deals due to its reliance on volume data. When the MFI moves in the opposite direction of the stock price, it may be used to predict a trend shift.
Put-Call Ratio (PCR)Indicator
The put-call ratio compares the amount of trades made using put options to call options. Rather than the absolute magnitude of the put-call ratio, fluctuations in its value imply a shift in market opinion.
When there are more calls purchased than puts, the ratio is greater than one, suggesting bullishness. When put volume exceeds call volume, the ratio falls below one, signaling bearishness. However, traders may use the put-call ratio as a contrarian indicator, choosing to trade against market trends in the expectation of a turnaround.
Open Interest (OI)
Open interest in options refers to open or unsettled contracts. OI does not always imply an uptrend or a downtrend, but it does give information about the strength of a trend. Increased open interest suggests fresh capital inflows and, hence, the continuation of the current trend, while dropping OI signals a deteriorating trend.
Consider the following for options traders aiming to profit from short-term market movements and trends:
Market/security is strong
Market/security is weakening
Market/security is weak
Market/security is strengthening
Can I Place Limit Orders on Options?
Limit orders are often used for trading single options as well as spreads. Market orders are sometimes utilized when a quick fill is required.
What Determines the Price of an Option?
Options pricing may be modeled in a variety of ways, but each one values an option differently dependent on the underlying price, strike price, time to expiry, interest rates, and volatility.
What Are the Risk Measures Used with Options?
Option risk is quantified using four separate factors known as “the Greeks.” These are the Delta, Theta, Gamma, and Vega.
The Bottom Line
In addition to the technical indicators described above, there are hundreds of additional indicators that may be employed for option trading (like stochastic oscillators, average true range, andcumulative tick).Variations occur with smoothing methods on resulting values, averaging concepts, and combinations of numerous indicators on top of that. After carefully reviewing the mathematical relationships and computations, an options trader should choose the indicators that are most suited to his or her trading style and technique.
Correction—10 August 2022: An earlier version of this article featured inaccurate put-call ratio data.
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