There are hundreds of technical indicators that traders can use depending on their trading style and the type of security being traded.
This article focuses on a few important technical indicators popular among options traders. Please also note that this article assumes knowledge of options terminology and the calculations involved in technical indicators.
Key points to remember
- RSI values range from 0 to 100. Values above 70 generally indicate overbought levels, and a value below 30 indicates oversold levels.
- A price move outside the Bollinger Bands can signal that an asset is ripe for a reversal, and options traders can position themselves accordingly.
- The intraday momentum index combines the concepts of intraday candlesticks and RSI, providing a suitable range (similar to RSI) for intraday trading by indicating overbought and oversold levels.
- A Cash Flow Index above 80 indicates that a security is overbought; a reading below 20 indicates the stock is oversold.
- The put-call ratio measures the volume of transactions using put options versus call options and changes in its value indicate a change in general market sentiment. Open interest provides indications of the strength of a particular trend.
How options trading is different
Technical indicators are often used in short term trading to help the trader determine:
- Range of motion (how much?)
- The direction of movement (in which direction?)
- Duration of the move (how long?)
Since options are subject to decay over time, the holding period becomes important. A stock trader can hold a position indefinitely, while an options trader is constrained by the limited time set by the option’s expiration date. Given time constraints, momentum indicators, which tend to identify overbought and oversold levels, are popular among options traders.
Let’s look at some common indicators – momentum and others – used by options traders.
Relative Strength Index (RSI)
The relative strength index is a momentum indicator that compares the magnitude of recent gains to recent losses over a specified period of time to measure a security’s speed and pattern of price movements for the purpose of determining overbought and oversold conditions . RSI values range from 0 to 100, with a value above 70 generally considered to indicate overbought levels and a value below 30 indicating oversold levels.
The RSI works best for individual stock options, as opposed to indices, because stocks display overbought and oversold conditions more frequently than indices. Highly liquid, high-beta stock options are the best candidates for short-term RSI-based trading.
All options traders are aware of the importance of volatility, and Bollinger Bands are a popular way to measure volatility. The bands widen as volatility increases and contract as volatility decreases. The closer the price gets to the upper band, the more the security can be overbought, and the closer the price gets to the lower band, the more it can be oversold.
A price move outside the bands can signal that the security is ripe for a reversal, and options traders can position themselves accordingly. For example, after a break above the upper band, the trader can initiate a long sell position or a short buy position. Conversely, a break below the lower band may represent an opportunity to use a long buy or short sell strategy.
Also, in general, keep in mind that it often makes sense to sell options in times of high volatility, when option prices are high, and to buy options in times of low volatility, when options are cheaper.
Intraday Dynamics Index (IMI)
The Intraday Momentum Index is a good technical indicator for high frequency options traders looking to bet on intraday moves. It combines the concepts of intraday candlesticks and RSI, thus providing a suitable range (similar to RSI) for intraday trading by indicating overbought and oversold levels. Using IMI, an options trader may be able to spot potential opportunities to initiate a bullish trade in an uptrend market during an intraday correction or initiate a bearish trade in a trending market bearish during an intraday price rise.
It is important to be aware of the “trend” of price movements. When there is a strong bullish or bearish trend visible, momentum indicators frequently show overbought/oversold readings.
To calculate IMI, the sum of active days is divided by the sum of active days plus the sum of inactive days, or ISup ÷ (ISup + IS down), which is then multiplied by 100. While the trader can choose the number of days to watch, 14 days is the most common time frame. Like RSI, if the resulting number is above 70, the stock is considered overbought. And if the resulting number is less than 30, the stock is considered oversold.
Money Flow Index (IMF)
The Cash flow index is a momentum indicator that combines price and volume data. It is also known as volume-weighted RSI. The MFI indicator measures the movement of money into and out of an asset over a specific period of time (usually 14 days) and is a “trading pressure” indicator. A reading above 80 indicates a stock is overbought, while a reading below 20 indicates the stock is oversold.
Due to the reliance on volume data, the MFI is better suited to stock option trading (as opposed to index-based trading) and longer term trading. When the MFI moves in the opposite direction in the stock price, it can be a leading indicator of a change in trend.
Put-Call ratio indicator (PCR)
The put-to-call ratio measures trading volume using put options versus call options. Instead of the absolute value of the put-call ratio, changes in its value indicate a change in general market sentiment.
When there are more call buys than sells, the ratio is greater than 1, indicating an uptrend. When the sell volume is greater than the call volume, the ratio is less than 1, indicating a decline. However, traders sometimes view the put-call ratio as a contrarian indicator, choosing to trade against market trends in hopes of an imminent reversal.
Open Interest (OI)
open interest indicates open or unsettled option contracts. The OI does not necessarily indicate a specific bullish or bearish trend, but it does provide indications of the strength of a particular trend. The increase in open interest indicates new capital inflows and hence the sustainability of the existing trend, while the decrease in OI indicates a weakening trend.
For options traders looking to profit from short-term price movements and trends, consider the following:
|Rising||Rising||The market/security is strong|
|Rising||Fall||The market/security is weakening|
|Fall||Rising||The market/security is weak|
|Fall||Fall||The market/security is getting stronger|
Can I place limit orders on options?
Yes, limit orders are common for trading simple options as well as spreads. Market orders are also used when immediate filling is needed.
What determines the price of an option?
Option prices can be modeled in many ways, but each values an option based on the following variables: the underlying price, strike price, expiration time, interest rates, and volatility.
What are the risk measures used with options?
In addition to the technical indicators mentioned above, there are hundreds of other indicators that can be used to trade options (like stochastic oscillators, mean true range and cumulative tick). In addition to this, variations exist with smoothing techniques on the resulting values, averaging principles and combinations of various indicators. An options trader should select the most suitable indicators for his trading style and strategy, after carefully considering the mathematical dependencies and calculations.
Correction—August 10, 2022: A previous version of this article contained incorrect information about the put-to-call ratio.