Technical Indicators for Options Trading

In this article, we will discuss

• The Importance of Technical Analysis in Options Trading
• Technical Indicators for Options Trading
• Conclusion

If you have been trading in the stock market, you may be familiar with technical analysis and trading indicators. For traders with a short-term outlook, such stock trading indicators are important sources of information about the price trends in the market. Samco Securities helps traders improve their trading performance by offering access to real-time technical indicators and technical analysis tools free of cost on the Samco trading app.

However, these indicators hold great significance for traders in other market segments too. This is particularly true in options trading. If you are eager to trade in options, you must know which technical indicators are important for your options trading strategy.

In this article, we take a closer look at the top technical indicators you need to focus on for options trading.

The Importance of Technical Analysis in Options Trading

The stock indicators used in technical analysis have far greater relevance in the options market. This is because of the time constraints in options trading. Let us explore this further.

When you purchase a company’s shares, you can technically hold it perpetually, without any end date in the picture. So, the timeline for a trade in the stock market can be ultra-long-term, if you want to hold your shares for many years. However, this is not the case in the options market. Options contracts have predetermined expiry dates that cannot be extended or cancelled. The expiry can be classified as near-month (i.e. in the same month as the trade), next-month (i.e. in the month after the trade) or the far-month (i.e. in the second month after the trade). This means options expiries range from 1 to 3 months for options trading.

With such a short-term outlook for each trade, it is even more crucial to utilise the best indicators for options trading in your F&O strategy. So, let us take a closer look at which indicators you need to factor in diligently.

Technical Indicators for Options Trading

The following technical indicators remain central to understanding the options market and creating an options trading strategy.

• Moving Averages

Moving averages are useful because they help you identify the overall price direction in options trading. You can use two types of moving averages — namely the exponential moving average (EMA) and the simple moving average (SMA) — for this purpose. The SMA is a simple mathematical average but the EMA is a weighted average that gives more importance to recent price movements.

This makes the EMA a very important technical analysis tool in options trading. You can use it to identify how the price of the underlying asset is trending and then take a position in the options market accordingly. If the asset price crosses above the EMA line, you may be looking at a bullish market. However, if the price crosses below the EMA line, a bearish market may be incoming.

• Relative Strength Index (RSI)

While the moving average tells you about the direction of price movement, the RSI tells you how quick and strong that price movement is. In options trading, where timing is critical because of the expiry of contracts, the RSI can be an invaluable momentum-based technical indicator for traders. Its value can help you understand if a security is overbought or oversold.

The RSI can be valued at any number from 0 to 100. If it is over 70, it means that the asset may be overbought and potential price correction may be imminent. This may be an opportunity to consider put options. Conversely, if this trading indicator is below 30, it means the market is oversold — which may be a sign to consider call options instead.

• Intraday Momentum Index (IMI)

The IMI is one of the best indicators for options trading if you plan to execute intraday trades. It brings together two pivotal signals — namely, the RSI and candlestick indicators — to give you a clearer picture of how the market is poised to move before the trading session closes. This trading indicator considers the relationship between the opening price and the closing price, so you can quickly identify oversold or overbought conditions.

Interpreting the intraday momentum index is quite similar to reading RSI values. Anything over 70 points to an overbought market, while anything below 30 indicates an oversold scenario. However, since the IMI technical indicator is designed to analyse short-term intraday price movements, it is particularly useful for intraday options trades.

• Bollinger Bands

Studying price trends and momentum is just as important as evaluating market volatility, especially in the options market where prices can change rapidly and significantly. What’s more, volatility (and implied volatility) also greatly influences options strike prices. With Bollinger Bands, you can assess how volatile the market is.

This technical analysis tool consists of three bands. The middle band is a 20-period SMA, while the upper and lower bands represent standard deviations from the SMA. The further apart the outer bands are from the middle band, the more volatile the market is. You can evaluate this technical indicator to get a clear idea of the level of volatility you can expect. This information is crucial for choosing appropriate options trading strategies in volatile markets.

• Money Flow Index (MFI)

Like the price and volatility, there is a third aspect of the markets that you must analyse before you start options trading. This is the trading volume. The money flow index is a trading indicator that combines volume and price analysis, which is why it is often called the volume-weighted RSI. The MFI is crucial for trading in the options market because trading volume can greatly influence how options prices move.

Like the RSI, the MFI can also give you signals about overbought and oversold instruments. High MFI values, typically above 80, are indicative of overbought markets that may be due for a downward reversal. On the other hand, low MFI values, like those below 20, may be a sign of oversold markets.

• Put-Call Ratio (PCR)

In the options market, trader sentiment is a significant price driver. The put-call ratio tells you the overall sentiment and mood of the market. As the name indicates, this technical indicator compares the trading volume (or open interest) of puts with the trading volume (or open interest) of calls.

While the absolute value of the PCR can give you some idea of who dominates the market, you must also track the change in PCR because this can tell how the market sentiment is changing. PCR changes can, therefore, let you know in which direction the price of options may move, so you can capitalise on these expected price movements.

When the PCR is above 1, it indicates more puts traded than calls, suggesting bearish sentiment. You could consider buying put options or selling call options to align with the market's pessimistic outlook. Conversely, when the PCR is below 1, it suggests more calls traded than puts, indicating bullish sentiment. You could buy call options or sell put options to capitalise on the market's optimistic view.

• Open Interest (OI)

The open interest (OI) represents the total number of open options contracts in the market. In the context of options trading, OI is a vital indicator as it provides insight into the strength of a price trend. This can help you decide whether to hold onto your options contracts or consider new trades.

An increase in OI suggests that new contracts are being opened. This indicates that the current trend may continue. On the other hand, a decrease in OI might indicate that the trend is losing strength, which could signal a reversal. Understanding OI can ultimately help you make informed decisions, particularly in a market as dynamic as the options segment.

Conclusion

The bottom line is that technical analysis and trading indicators can vastly improve the potential success of your options trading strategy. Trading blindly, without considering these metrics, can lead to losses more often than not. So, to avoid such misinformed trades, ensure that you account for these technical indicators in the options market.

Samco Securities offers you access to these indicators and a wide range of trading charts on the Samco trading app. These features and more are all available free of cost if you have a Samco demat and trading account. Don’t have one yet? Open yours today to get access to live market indicators and improve your trading strategy.

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