Technical indicators come into play in options trading when you need to determine turning points for underlying stock and the trends that get them to this point. When used correctly, they can help to determine the optimal time to buy or sell and also predict movement cycles. In general, technical indicators are calculated based on the pricing pattern of the underlying stock. Relevant data includes highs and lows, opening price, volume, and closing price. They typically take into account the data regarding a stock’s price from the past few periods, based on the charts the person who is doing the analysis prefers.
This information is then used to identify trends that show what has been happening regarding a specific stock and then using past information to determine likely results for the future. Technical indicators come in both leading and lagging varieties. Indicators that lag are based on data that already exists and make it easier to determine if a trend is in the process of forming or if the stock in question is simply trading within a range. The stronger the trend that the lagging indicator pinpoints the greater the chance it is going to continue into the future. They typically drop the ball when it comes to predicting potential pullbacks or rally points, however.
When it comes to leading indicators, they are mainly useful when you are looking to predict the point in the future where the price of a specific stock is going to crash or rally. More often than not, these are going to be momentum indicators that, as the name implies, gauge the strength of the movement the underlying stock is going to undertake. Leading indicators tend to come in handy when you need to determine if the price the stock in question has reached is untenable in the long run and, if so, when the slowdown of the current trend is likely to occur. Because both oversold and overbought stocks are guaranteed to experience a pullback, knowing when this move is going to occur will come in handy more likely than not.
Both types of indicators are equally useful at different times, and often in conjunction with one another as you will frequently need to know both what types of trends are forming and when they are ultimately going to peter out if you are going to want to utilize them most strategies successfully. In general, you are going to want to stick to a minimum of 3 indicators at all times.
Moving average convergence divergence indicator:
The moving average convergence divergence (MACD) indicator is a type of oscillating indicator that generally moves between the centerline and zero. If the MACD value is high, then this indicates the related stock is close to being overbought, and if the value is low then the stock is in danger of being oversold.
MACD charts are generally based on a combination of multiple exponential moving averages (EMAs). These averages can be based on any time frame, though the most common is the 12-26-9 chart. This chart is typically broken into multiple parts, the first of which is the 26-day and 12-day chart. Using an EMA that is slower or fast allows you to more accurately gauge the current momentum level for the trend you are currently keeping an eye on. If the 12-day EMA, the fast of the pair, ends up being above the 26-day EMA then you can safely assume that the underlying stock is in an uptrend while the reverse will also be the case.
If the 12-day EMA increases at a rate that is greater than the 26-day EMA, then the uptrend is generally going to be even more pronounced. IF the 12-day EMA starts to move closer to the 26-day, then you can accurately assume that it is slowing down which means the momentum of the trade is going to fade. This, in turn, means you should expect the uptrend to end shortly.
The MACD puts these EMAs to use by considering the difference between them and then plotting it out. If the 26-day and the 12-day end up being the same, then the MACD will equal out to 0. If the 12-day ends up at a higher point than the 26-day, then the MACD will end up being positive. Otherwise, it will be negative. The larger the difference between them, the further the MACD line will fall from zero if the result is negative, or from the centerline if the result is positive.
By itself, this line does not provide any information that you would not be able to find from a simple moving average. However, it becomes much more useful once the 9-day EMA is taken into account as well. The 9-day EMA is different from the other 2 in that it shows the trend of the MACD line rather than the stock price. This means the 9-day EMA smooths out the movement of the MACD line to make its results more manageable.
In addition to the 9-day EMA, you are also going to want to look at the MACD histogram which looks at the difference between it and the base MACD line. When the MACD line crosses above the 9-day EMA, the MACD histogram will typically cross above 0 and thus indicate a bullish signal. If it crosses on the other side of 0, then you can take that to indicate a trend that will turn bearish if it has not already. When put to a chart, the histogram will form in a series of peaks that descends if the underlying stock is experiencing negative divergence and will generate a series of ascending peaks if it is experiencing positive divergence.
If the result generates a trend indicating negative divergence then you can feel relatively certain that the current positive trend is going to hit a level of resistance that it will not be able to overcome and, thus, reverse sooner than later. This can happen even if the pattern of the underlying stock has not started to run out of momentum quite yet. The same can be said about positive divergence and a negative trend. It is also important to keep in mind, however, the fact that these signals can become muddied if the price trades at or near the maximum range for a prolonged period. This means for the best results you are always going to want to use multiple indicators at once to prevent yourself from giving in to false signals.
Average directional index:
The average directional index can be thought of as a guidepost that confirms the signals that other technical indicators bring to light. After a trend has been identified successfully, the average directional index can then more easily determine its strength compared to the other trends that are currently taking place. The average directional index is a combination of directional indicators that are both negative and positive and thus can more easily track trends regardless of their direction. They are then unified in a way that determines the overall strength of the trend.
As an oscillating indicator, the average directional index ranges between 100 and 0. The low end indicates that the trend is essentially flat and without volatility while the high end indicates that the stock is virtually moving straight up and down very quickly. This indicator is only useful when it comes to measuring the overall strength of the trend, not which direction it is moving in or is likely to move in anytime soon.
As a general rule, it is rare to see an average directional index value above 60. This is because trends with that much strength are only likely to appear in periods of deep recession or extremely long bullish market runs. What this means is that a value of anything greater than 40 can be considered a vibrant trend and anything lower than 20 indicates an underlying stock within a trading range.
When watching for average directional index signals, if a trend moves from above 40 to below it, then you can assume the current trend is slowing which means it may be time to mix up your current trading strategy or close out any existing positions. However, if you see a trend start at less than 20 and then increase to a point near 40 then you will know that a neutral market is starting to pick up steam and a major trend is likely going to be formed.
It is also important to always keep in mind the point where the negative directional index and the positive directional index cross. If the negative directional index is crossed by the positive in an upward direction, then you can assume the market is feeling bullish. If things happen the other way, then you can expect bearish trends instead.
Relative strength index:
The relative strength index (RSI) is another type of momentum indicator that compares the relative magnitude of recent losses when compared to recent gains as a means of determining if a given stock is oversold or overbought. This, in turn, allows it to generate vital indications about the correlating reversals or corrections that are forthcoming, making price movements in the short-term clearer.
RSI is most effective when used to measure individual stocks as opposed to indexes because it is more likely the individuals will experience either condition. RSI values range from 0 to 100. Any value above 70 shows the stock is overbought and anything under 30 shows it is undersold. In general, options that are on high beta stocks with high liquidity are going to provide the best RSI results.
Some traders find that the RSI provides the most effective information when it is compared to crossovers with the short-term moving average. With the help of a 25-day and a 10-day moving average, you will likely be able to easily discern crossovers that show that a direction shift will occur in periods where the RSI is either in the range of 80 and 20 or 70 and 30. Regardless of what it shows, the RSI is always going to indicate a period of reversal, regardless of the precise direction.
The concept known as failure swings can make it easier for investors to take full advantage of the information shown through an RSI. It is important to keep in mind that just because the RSI shows either something in the range of 30 or 70, does not mean that the reversal is going to happen right away. Rather, positions can remain in overbought or oversold positions for an extended period. When the RSI extends to these levels, you are going to want to start watching the volume indicators to make it clear when traders start taking profits at the top or building up at the bottom. To make the most of this tool, it may be helpful to study old charts as a means of determining the types of price action you are likely to see at the opposite ends of an RSI, so you know what to expect.
Bollinger Bands:
The importance of volatility when it comes to correctly valuing an option is well known. This is why Bollinger bands are so useful as they make it easy to grasp this facet of a particular stock, in turn, making it easier to identify lower and upper ranges. They work by generating bands based on the way the stock price has recently been moving. Bollinger bands tend to provide 2 types of indications:
- The bands tend to contract and expand depending on how volatility decreases or increases based on the way the price has been moving recently. If the bands expand then volatility is increasing, if they contract then volatility is decreasing. With this in mind, you can feel safer taking on reversal-based option positions.
- The range of the current band can also be compared to the current market price as a means of determining any potential breakout patterns. If the breakout occurs at the top of the band, then you know the market has been overbought which means it is time to buy puts or short existing calls. If the breakout occurs at the bottom of the lower band, then you know the market is oversold which means it is time to buy short puts or calls that come with lower overall volatility.
- Either way, it is important to take care to assure the current volatility as shorting options if volatility is high can be beneficial. It can lead to higher premiums if volatility is high and cheaper options if volatility is low. The best value for a Bollinger band is up to the trader. However, the most commonly used value is 2 for the standard deviation of the top and bottom bands and 12 for the simple moving average.
The squeeze is the core concept of Bollinger bands as when the bands come close together they constrict the moving average and squeeze it tight, hence the name. A squeeze indicates that the volatility is going to be low for a time while the future likelihood is going to be increased, as will the number of potentially profitable opportunities to trade. On the other hand, the wider the bands end up being, the greater the likelihood of decreased volatility and the higher the likelihood that it is time to exit the trade. It is important to keep in mind that these two conditions are not trading signals in the traditional sense. The bands themselves give no true indication of what direction the price is likely to move in or when the potential change will take place.
Overall, it is important to keep in mind that Bollinger bands are not designed to be used in a vacuum. Rather, they are better served as an additional indicator which can then provide traders with additional information when it comes to the volatility of the price. Ideally, you will want to use them with at least 2 other indicators that are non-correlated and also provide market signals that are more direct. Using Bollinger bands under these circumstances will help you to discover opportunities that you may have otherwise missed with an overall higher degree of success.
Intraday Momentum Index:
If you tend to trade options more frequently than the average trader you are going to want to pay attention to the intraday momentum Index (IMI) as it is a useful indicator when it comes to intraday trades. It utilizes candlesticks along with an RSI to create a useful intraday trading range by showing off oversold and overbought markets. It is important to take into account how trendy these price moves as if there is a visible, strong trend then the indicator might give off a false positive and read it as an oversold or overbought opportunity.
If you are aware of these trends, and also make use of the IMI, then you will have the ability to spot these types of incidents sooner than you otherwise would, making it possible to get into an early long position while the market is still on the uptrend or get into a short position if it is in a downtrend. You can determine the IMI with the following calculation.
- If Close > Open: Gains = Gain (n-1) (Close – Open); Losses = 0
- If Close < Open: Losses = Loss (n-1) (Open – Close); Gains = 0
- Add Gains and Losses for past n chosen periods
- IMI = 100 x (Gains / (Gains Losses))
When combined with the possibility of leverage, the IMI can be a profitable technical indicator to use while you are trading options. The formula is also flexible in that each trader can use the n value that suits them best. Commonly used values include 70 or above for markets that are overbought and 30 or less for markets that are oversold.
Money Flow Index:
If you are looking for a type of technical indicator to use as a complement to the RSI, the money flow index is a reliable choice. It combines volume and price data as a means of identifying price trends in a given stock. It is also sometimes called the volume-weighted RSI. As volume is taken into consideration, this indicator can generate useful inputs regarding the amount of capital is moving into and out of the chosen stock over a set period of time. The most commonly used time frame is 14 days.
The value for the MFI is always going to be somewhere between 0 and 100 and can be calculated via multiple steps.
- First, you are going to need to determine the average price.
- Second, you are going to calculate the raw money flow.
- Then you will need to determine the money flow ratio as determined by the amount of negative and positive money flow that the stock has seen in the previous 14 days.
- Finally, you will calculate the MFI via the money flow ratio.
The calculations for doing so are outlined below:
- Typical price = (high price low price closing price) / 3
- Raw money flow = typical price x volume
- Money flow ratio = (14-days Positive Money Flow) / (14-days Negative Money Flow)
- MFI = 100 – 100 / (1 money flow ratio)
You can find the negative money flow by adding together all of the amounts for days where the typical price was lower than the previous typical price. The opposite applies to positive flow. It is common for traders to keep an eye out for opportunities that come into existence when the MFI moves in the opposite direction of the current price as this often signals a leading indicator that shows change is about to affect the current trend.
Put call ratio indicator:
The put call ratio indicator (PCR) is useful when you need to determine the volume of call or put options that a given stock has attached to it. Rather than dealing in absolute value, the PCR indicates when the market’s sentiment is changing. The greater the change in its value, the greater the change in the market as a whole. If the value drops, then this indicates a bullish trend which means more calls are being used. Likewise, a value that increases in value is going to show a trend towards bearishness and more puts overall.
As it is dependent on data regarding volume, the MFI indicator is especially useful for options trading based on stocks as opposed to indices. It is also known to see better results for longer forms of options trading than with intraday trading. In general, you will want to look for scenarios where the MFI indicator moves away from the stock price as this is generally a leading indicator that signals a trend reversal is coming. The best values to base your predictions on are going to be 20 for oversold and 80 for overbought.
There are two primary types of financial instruments, these include the primary securities and instruments as well as other instruments whose value is wholly derived based on their relationship to the primary instruments. When it comes to options, those underlying assets are securities which is what this indicator is looking at.
