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5 Indicators I Use When Options Trading

Updated on January 12, 2021
Calls and Puts
Calls and Puts | Source

What is Options Trading?

Options are essentially a type of derivative security. It is a contract giving the buyer the right, but not the obligation to purchase or sell a specific stock at the strike price. So what is a strike price? A strike price is the price you think the underlying stock will go above (call) or below (puts) on or before an expiration date. Why would we do options trading instead of trading stocks directly? Let's say, you want to purchase Tesla (TSLA) shares, their current price is $857.50 per share so to purchase 100 shares will cost you $85,750 whereas if we were to purchase one option contract (which equates to 100 shares) will only cost around $4,900 depending on the strike price we choose. When we play options, we are speculating the direction of the stock.

A sample options chain
A sample options chain

Calls vs. Puts

When a trader purchases a call, they are expecting the stock to rise above the strike price, whilst purchasing a put, is the opposite; they are expecting the stock to dip below the strike price.

For example, if we look at the below picture, a strike price of $26.00 will cost the trader $0.74*100 per contract for a call for an expiration of January 15th, 2020. Why do we multiply $0.74 by 100? Well, a single contract equates to 100 shares, and so, to purchase this option, it will cost the trade $74.00 per contract. By doing this, the trader thinks this stock will go above $26.00 before said date. If it does, then the $0.74*100 per contract they paid for will go up and thus can be sold for a profit. Puts is the completely opposite as thus the price will be different. So for the same strike price of $26.00, a put contract will be $0.84*100. When a trader purchases a put, they are expecting the stock to go below said strike price. If they are right, the price for contract will go up. How much will each call and put contract go up by? It all depends on their delta values. We will leave that for another time.

Indicators to Use

Nothing in the stock market is 100% certain. All we can do is use indicators to assist us in confirming a specific direction as to minimize our risk. Every trader uses their very own set of indicators but below are the top five I use to help me in determining and confirming the direction the stock will likely go. VWAP, MACD, RSI, Bollinger Bands, and finally, MFI. We will go into detail describing each of these indicators.

VWAP - Volume Weighted Average Price

The Volume Weighted Average Price, or more commonly known as the VWAP, is a trading indicator that is calculated by taking the number of shares bought times the share price and then dividing by total shares bought.

Basically it calculates the average price of the stock based on how many shares were traded at different prices and its usually calculated within a one day time frame. The VWAP is displayed on the chart as a moving average but is much slower moving than your 8 and 20 day moving averages.

This is a key indicator and guideline for institutions and pension plans that look to take large positions and need to know whether they are getting in at a good price or not.

It also allows them to get into positions without disrupting the market or elevating prices unnaturally with their large orders, resulting in unfavorable entry prices for them.

The VWAP is a major level of importance that a lot of big traders and institutions monitor and is why you should be paying attention to it too

VWAP indicates the direction
VWAP indicates the direction | Source

MACD - Moving Average Convergence/Divergence

The Moving Average Convergence/Divergence oscillator (MACD) is one of the simplest and most effective momentum indicators available. The MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter one. As a result, the MACD offers the best of both worlds: trend following and momentum. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals. Because the MACD is unbounded, it is not particularly useful for identifying overbought and oversold levels.

As its name implies, the MACD is all about the convergence and divergence of the two moving averages. Convergence occurs when the moving averages move towards each other. Divergence occurs when the moving averages move away from each other. The shorter moving average (12-day) is faster and responsible for most MACD movements. The longer moving average (26-day) is slower and less reactive to price changes in the underlying security.

The MACD line oscillates above and below the zero line, which is also known as the centerline. These crossovers signal that the 12-day EMA has crossed the 26-day EMA. The direction, of course, depends on the direction of the moving average cross. Positive MACD indicates that the 12-day EMA is above the 26-day EMA. Positive values increase as the shorter EMA diverges further from the longer EMA. This means upside momentum is increasing. Negative MACD values indicate that the 12-day EMA is below the 26-day EMA. Negative values increase as the shorter EMA diverges further below the longer EMA. This means downside momentum is increasing.

When the signal line diverges from the average in a downward trend, the price will likely dip while when it diverges in an upward trend, prices will go up.
When the signal line diverges from the average in a downward trend, the price will likely dip while when it diverges in an upward trend, prices will go up. | Source

RSI - Relative Strength Index

The relative index is a momentum indicator that compares the magnitude of recent gains to recent losses over 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 indicate overbought levels, and a value below 30 indicating oversold 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.

Overbought and oversold stock will usually face a retracement.
Overbought and oversold stock will usually face a retracement. | Source

Bollinger Bands

All options traders are aware of the importance of volatility, and Bollinger bands are a popular way to measure 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 the price moves to the lower band, the more oversold it may be.

A price move outside of the bands can signal the security is ripe for a reversal, and options traders can position themselves accordingly. For instance, after a breakout above the top band, the trader may initiate a long put or a short call position. Conversely, a breakout below the lower band may represent an opportunity to use a long call or short put strategy.

Stocks usually trade between the upper and lower bands.
Stocks usually trade between the upper and lower bands. | Source

MFI - Money Flow Index

The Money Flow Index is 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." A reading over 80 indicates that a security is overbought, while a reading below 20 indicates that the security is oversold.

Due to dependency on volume data, MFI is 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.

Shows the amount of money going in and out of a stock.
Shows the amount of money going in and out of a stock. | Source

Conclusion

There are a correct set of indicators to use when trading options, but these five can definitely have a trader started. Many platforms now a days have paper trading options where we can practice with virtual money and I highly advise this is where everyone should start. Options trading is extremely lucrative when done correctly. There are traders out there who do it as a full time job where they just put in couple hours a day and can turn profits of millions.

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