The main technical indicators of option trading

Depending on the trading style and the type of securities to be traded, traders can use hundreds of technical indicators. This article focuses on some important technical indicators that are popular among option traders. Please also note that this article assumes that you are familiar with the option terms and calculations involved in technical indicators.

(If you are not sure whether technical trading or options are right for you, please check InvestingClue Introduction to the types of stock traders Tutorial to decide which style you like. )

What’s different about options trading

Technical indicators are often used in short-term trading to help traders determine:

  • Range of motion (how much?)
  • The direction of movement (in which direction?)
  • The duration of the movement (how long?)

Since options are affected by time decay, the holding period is very important. Stock traders can hold positions indefinitely, while option traders are restricted by the time limit set by the option expiration date. Given the time constraints, momentum indicators that tend to identify overbought and oversold levels are popular among option traders.

Let’s take a look at some common indicators used by option traders-momentum indicators and other indicators.

Key points

  • The RSI value ranges from 0 to 100. Values ​​above 70 usually indicate overbought levels, and values ​​below 30 indicate oversold levels.
  • Price movements outside the Bollinger Bands may indicate that the time for asset reversals is ripe, and option traders can position themselves accordingly.
  • The intraday momentum index combines the concepts of intraday candlesticks and RSI, and provides a suitable range for intraday trading (similar to RSI) by indicating overbought and oversold levels.
  • A fund flow index above 80 indicates that the security is overbought; a reading below 20 indicates that the security is oversold.
  • The put option ratio measures the trading volume of put options and call options, and changes in their value indicate changes in overall market sentiment.
  • Open positions provide an indication of the strength of a particular trend.

Relative Strength Index (RSI)

The relative strength index is a momentum indicator that is used to compare the magnitude of recent gains and recent losses within a specified time period to measure the speed of securities and the speed of price changes to determine overbought and oversold conditions. The RSI value ranges from 0-100. It is generally considered that a value higher than 70 indicates an overbought level, and a value lower than 30 indicates an oversold level.

RSI is most suitable for options on individual stocks, not indexes, because stocks are more frequently overbought and oversold than indexes. Options on stocks with high liquidity and high beta are the best choice for short-term trading based on RSI.

Bollinger Bands

All option traders know the importance of volatility, and Bollinger Bands are a popular way of measuring volatility. These bands expand as volatility increases and shrink as volatility decreases. The closer the price is to the upper limit, the more the security may be bought, and the closer the price is to the lower limit, the more it may sell.

Price movement outside the range can indicate that the security has matured and can be reversed, and option traders can position themselves accordingly. For example, after breaking the top band, a trader may initiate a long put option or a short call option position. Conversely, breaking the lower limit may represent an opportunity to use a long bullish or short bearish strategy.

Also, in general, remember that it usually makes sense to sell options during periods of high volatility when option prices are high, and buy options during periods of low volatility when option prices are lower.

Intraday Momentum Index (IMI)

The intraday momentum index is a good technical indicator for high-frequency option traders who want to bet on intraday trends. It combines the concepts of intraday candlesticks and RSI to provide a suitable range for intraday trading (similar to RSI) by indicating overbought and oversold levels. Using IMI, option traders may be able to spot potential opportunities to start bullish trading in an uptrend market during intraday adjustments, or start bearish trading in a downtrend market when intraday prices are skyrocketing.

It is important to pay attention to the “trend” of price changes. When there is a strong uptrend or downtrend, the momentum indicator will often show overbought/oversold readings.

To calculate IMI, divide the sum of up days by the sum of up days plus the sum of down days, or ISup ÷ (ISup + IS down), and then multiply by 100. Traders can choose the number of days to see, 14 days is the most common time range. Like RSI, if the resulting number is greater than 70, the stock is considered overbought. If the resulting number is less than 30, the stock is considered oversold.

Money Flow Index (MFI)

The Money Flow Index is a momentum indicator that combines price and transaction volume data. It is also called volume weighted RSI. The MFI indicator measures the inflow and outflow of capital into and out of assets within a certain period of time (usually 14 days) and is an indicator of “trading pressure”. A reading above 80 indicates that the security is overbought, while a reading below 20 indicates that the security is oversold.

Due to its reliance on trading volume data, MFI is more suitable for stock-based option trading (rather than index-based) and longer-term trading. When MFI and stock prices move oppositely, this may be a leading indicator of trend changes.

Put Option (PCR) indicator

The put option ratio measures the trading volume of put options and call options. Changes in its value indicate changes in overall market sentiment, rather than the absolute value of put options.

When there are more put options than call options, the ratio is higher than 1, indicating a put. When the bullish volume is higher than the bearish volume, the ratio is less than 1, indicating bullishness. However, traders also view the put option ratio as a contrarian indicator.

Open interest (OI)

Open interest refers to the open interest or unsettled contract in the option. OI does not necessarily indicate a specific uptrend or downtrend, but it does provide an indication of the strength of a specific trend. An increase in open interest indicates new capital inflows and therefore the sustainability of the existing trend, while a decrease in OI indicates a weakening of the trend.

For option traders who wish to benefit from short-term price changes and trends, please consider the following:

price

Open position

explain

Rise

Rise

The market/security is strong

Rise

come down

Market/security is weakening

come down

Rise

Weak market/security

come down

come down

Market/security is strengthening

Bottom line

In addition to the above technical indicators, there are hundreds of other indicators that can be used to trade options (such as stochastic oscillators, average true ranges, and cumulative ticks). The most important thing is that there are changes in smoothing techniques in the combination of result values, averaging principles, and various indicators. After carefully checking the mathematical correlations and calculations, the options trader should choose the indicator that best suits his or her trading style and strategy.

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