There are hundreds of technical indicatorstraders can utilize depending on their trading style and the type of security to be traded.
This article focuses on a few important technical indicators popular among options traders. Also, please note that this article assumes familiarity with options terminology and calculations involved in technical indicators.
Key Takeaways
- RSI values range from 0 to100. Values above 70 generally indicateoverbought levels, and a valuebelow 30 indicatesoversold levels.
- A price moveoutside of theBollinger bands can signal an asset is ripe for areversal, and options traders can position themselves accordingly.
- 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 money flow index readingover 80 indicates that a security is overbought; a reading below 20 indicates that the security is oversold.
- The put-call ratiomeasurestrading volume using put options versuscall options and changes in its value indicate a change in overall market sentiment. The open interest provides indications about the strength of a particular trend.
How Options Trading Is Different
Technical indicators are often used inshort-term trading to help the trader determine:
- Range of movement (how much?)
- The direction of the move (which way?)
- Duration of the move (how long?)
Since options are subject to time decay, the holding period takes significance. A stock trader can hold a position indefinitely, while anoptions trader is constrained by the limited duration defined by the option's expiration date. Given the time constraints,momentum indicators, which tend to identify overbought and oversold levels, are popular among options traders.
Let's look at a fewcommon indicators—momentum and others—used by options traders.
Relative Strength Index (RSI)
The relative strength indexis a momentum indicator that compares the magnitude of recent gains to recent lossesover a specified period of time to measure a security's speed and change of price movements in an attempt to determine overbought and oversold conditions.RSI values range from 0-100, with a value above 70 generally considered to indicateoverbought levels, and a valuebelow 30 indicatingoversold levels.
RSI works best for options on individual stocks, as opposed to indexes, as stocks demonstrate overbought and oversold conditions more frequently than indexes. Options on highly liquid, high-beta stocks make the best candidates for short-term trading based on RSI.
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Bollinger Bands
All optionstraders are aware of the importance of volatility, andBollinger bandsare a popular way tomeasure volatility.The bands expand as volatility increases and contract as volatility decreases.The closer the price moves to the upper band, the more overbought the security may be, and the closer thepricemoves to the lower band, the more oversold it may be.
A price moveoutside of thebands can signal the security is ripe for areversal, and options traders can position themselves accordingly. For instance, after abreakoutabove the top band, the trader may initiate a long put or ashort callposition. Conversely, abreakout below the lower band may represent an opportunity to use a long call or short put strategy.
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Also, in general, keep in mind that it often makes sense to sell options in periodsof high volatility, when option prices are elevated, and buy options in periods of low volatility, when options are cheaper.
Intraday Momentum Index (IMI)
The Intraday Momentum Indexis a good technical indicator for high-frequency optiontraders looking to bet on intraday moves. It combines the concepts of intraday candlesticks and RSI, thereby 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 tradeinan up-trending market at anintraday correction or initiate a bearishtrade in a down-trending market at an intraday price bump.
It is important tobe aware of the “trendiness” of the price moves. When there is a strong visible uptrend or downtrend, momentum indicators will frequently show overbought/oversold readings.
To calculate the IMI,the sum of up days is divided by the sum of up days plus the sum of down days, or ISup ÷ (ISup + IS down), which isthen multiplied by 100. While the trader can choose the numberof days to look at,14 days is the most common time frame. Like RSI, if the resulting number is greater than 70, the stock is considered overbought.And if the resulting number is less than 30, the stock is considered oversold.
Money Flow Index (MFI)
TheMoney Flow Indexis a momentum indicator that combines price and volume data. It is also known as volume-weighted RSI. The MFI indicator measures the inflow and outflow of money into an asset over a specific period of time (typically 14 days), and is an indicator of"trading pressure."Areadingover 80 indicates that a security is overbought, while a reading below 20 indicates that the security is oversold.
Due to dependency on volume data, MFIis better suited to stock-based options trading (as opposed to index-based) and longer-duration trades. When the MFI moves in the opposite direction as the stock price, this can be a leading indicator of a trend change.
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Put-Call Ratio (PCR)Indicator
The put-call ratiomeasurestrading volume using put options versuscall options. Instead of the absolute value of the put-call ratio, the changes in its value indicate a change in overall market sentiment.
When there are more calls being bought than puts, the ratio is above 1, indicating bullishness. When put volume is higher than call volume, the ratio is less than 1, indicating bearishness.However, traders sometimes view the put-call ratioas acontrarianindicator, opting to trade against market trends in hope of an impending reversal.
Open Interest (OI)
Open interest indicates the open or unsettled contracts in options. OI does not necessarily indicate aspecific uptrend or downtrend, but it does provide indications about the strength of a particular trend. Increasing open interest indicates new capital inflow and,hence, the sustainability of the existing trend, while declining OI indicates aweakeningtrend.
For options traders looking to benefit from short-term price moves and trends, consider the following:
Price | Open Interest | Interpretation |
|---|---|---|
Rising | Rising | Market/security is strong |
Rising | Falling | Market/security is weakening |
Falling | Rising | Market/security is weak |
Falling | Falling | Market/security is strengthening |
Can I Place Limit Orders on Options?
Yes, limit orders are common for trading single options as well as spreads. Market orders are also used when an immediate fill is needed.
What Determines the Price of an Option?
Options prices can be modeled in a number of ways, but each value an option based on the following variables: the underlying price, the strike price, time to expiration, interest rates, and volatility.
What Are the Risk Measures Used with Options?
The risk content of options is measured using four different dimensions known as "the Greeks." These include theDelta,Theta,Gamma, andVega.
The Bottom Line
In addition to the above-mentioned technical indicators, there are hundreds of other indicators that can be used for trading options (like stochastic oscillators, average true range, andcumulative tick). On top of those, variations exist with smoothing techniques on resultant values, averaging principals and combinations of various indicators.An options trader should select the indicators best suited to his or hertrading style and strategy, after carefully examining the mathematical dependencies and calculations.
Correction—Aug.10, 2022: A previous version of this article contained incorrect put-call ratio information.
Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.
Constance M. Brown. "Technical Analysis for the Trading Professional, Second Edition: Strategies and Techniques for Today’s Turbulent Global Financial Markets." McGraw Hill Professional, 2011.
Bollinger Bands. "Bollinger Bands Rules."
Tushar S. Chande and Stanley Kroll. "The New Technical Trader." Wiley, 1994.
Fidelity. "Money Flow Index."
Schwab. "Ratio Spreads."
Fidelity. "Introduction to Options Part I of III: The Basics."
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