Best Indicators for Option Trading

Trading in options is a great way for traders and investors to profit from various market conditions. Different options trading strategies can be deployed to benefit in trending or sideways markets. However, option trading can prove to be challenging at times. With the help of technical indicators, one can develop trading strategies that fit their trading style and improve their trading experience. In this blog, let us look at some of the best indicators for options trading and how they can help.

Top Option Trading Indicators

Relative Strength Index (RSI)

The relative strength index (RSI) is one of the most commonly used indicators. The RSI is a momentum indicator that compares the speed and strength with which the price of an asset rose or fell. By ascertaining the momentum, the indicator can help one understand whether a security is overbought or oversold.

The RSI is measured in a range of 1-100. Typically, when a security's RSI is above 70, it is said to be in the overbought zone. If it is below 30, the security is in the oversold zone. The indicator is helpful in options trading analysis, as a trader can either exit long positions or go short when the security is overbought or vice versa.

Bollinger Bands

Volatility plays an important role in options trading, making Bollinger Bands one of the top option trading indicators. Bollinger Bands measure the volatility of a security. The range of the bands helps gauge volatility. A rise in volatility leads to an expansion in the bands, and lower volatility contracts the bands.

Bollinger bands consist of an upper and lower band. When the price moves closer to the upper band, the security is approaching the overbought zone and a break above it could result in a reversal. Similarly, the lower band signifies if a security is oversold. By analysing the price behaviour around the bands, traders can plan their entries and exits.

Intraday Momentum Index (IMI)

The Intraday Momentum Index (IMI) is another valuable option trading indicator that is similar to the RSI. The IMI is more suitable for intraday traders or high-frequency traders that aim to capitalise on intraday moves such as entering into a long position in an uptrend or going short at a retracement in a downtrend.

The IMI can be seen as a combination of intraday candlestick and RSI concepts. It is calculated by dividing the total number of up days by the total number of up days plus the total number of down days and then multiplying it by 100. Similar to the RSI, if the IMI is above 70, it indicates that the security is overbought, and if it is below 30, the security is oversold.

Money Flow Index (MFI)

Apart from trading index options, traders can also trade stock options. One of the best option trading indicators for stocks is the Money Flow Index (MFI). The MFI is a momentum indicator that measures the inflow and outflow of money in a particular security over a period.

The MFI is also known as the volume-weighted RSI and indicates the trading pressure. It considers the volume of a security making it a more suitable indicator for stocks. The MFI is measured in a range of 1-100. If the MFI is above 80, the security is overbought and if it is below 20, the security is oversold.

Put-Call Ratio (PCR) Indicator

When it comes to option trading analysis, the Put-Call Ratio (PCR) Indicator is a handy tool that a trader should have in the toolkit. This indicator helps gauge the market sentiment by measuring the change in the total value of puts and calls.

When the PCR Indicator is above 1, it signifies that more calls are being purchased and the market shares a bullish sentiment. If the PCR Indicator is below 1, it indicates bearishness in the market as more puts are being bought than calls. In some cases, traders use the PCR Indicator as a contrarian indicator and use it to enter trades in the opposite direction.

Open Interest (OI)

Open Interest (OI) is one of the most crucial parts of options trading. The OI can be used as an option chain indicator. The OI measures the number of open contracts at a particular strike price. Although the indicator does not indicate the direction of the trend, it can be used to gauge the strength of the underlying trend.

OI is often used in conjunction with the price to analyse the trend. Since the OI signifies the number of open or unsettled contracts, an increase in the open interest indicates that the underlying trend is strong and will be sustained. A decline in OI indicates that the trend is losing steam. Traders can make use of OI to hedge their positions or deploy more complex options trading strategies.