Best Indicators for Trading Options Like a Pro

A crucial tool for traders and investors is technical indicators that show potential trading opportunities, analyze current market trends, and give insights into how to effectively manage risk. The more that traders can work into a variety of technical indicators into their trading routine, the more success they’ll likely experience in the long run.

Professional traders rely on indicators for timing entries, exits, and risk management.

If you’re curious about which are the best indicators to use for the current market conditions and your personal trading style, keep reading our guide where we will highlight the top technical indicators that can help your trade options like a pro.

What Are Technical Indicators?

Traders and investors use technical indicators to analyze market trends and predict future price movements. These mathematical calculations are great for making decisions without buying and selling assets. Plotted on charts, they are based on historical price and volume data and can be helpful when identifying trends, momentum potential price points, and volatility. Good examples of technical indicators include Bollinger Bands, Moving Averages, Relative Strength Index, Fibonacci Retracement, and Moving Averages Convergence Divergence (MACD).

Technical indicators help traders make informed decisions based on historical data. Since technical indicators are mathematical calculations that are based on the price or volume data of a financial asset, they’re perfect for traders looking to correctly analyze the markets and make sound decisions on the best assets to buy or sell.

• Leading Indicators: These metrics are used to predict future outcomes and trends to help traders identify potential problems or opportunities before they occur. Leading indicators allow traders to make proactive adjustments to their investments. They are a forward-looking measure that can be influenced by actions and can help to anticipate future performance.
• Lagging Indicators: These metrics are used to measure past outcomes, which reflect on past events to allow traders to identify areas of improvement. Unlike leading indicators, lagging indicators are backward-looking metrics that focus on what worked or didn’t work in the past.

When it comes to using technical indicators, traders or investors should combine multiple indicators for better accuracy. Relying too heavily on any one indicator can lead traders to make false assumptions about the current state of the market. You need a few other technical indicators to prove that what you’re seeing with one technical indicator is part of a greater trend or a one-off occurrence.

The Best Indicators for Trading Options Like a Pro

Let’s take a look at the most common and popular technical indicators that options traders like to use. Hundreds could be put to task, but we’d like to outline the best of the best, so you can find the indicator to work best for the type of security you’re trading as well as one that works well for your personal trading style.

1. Moving Averages (MA & EMA)

There are a few types of moving averages that online traders use to take time series data and smooth out short-term fluctuations, and highlight longer-term trends, all to get their bearings straight and properly navigate market trends without making impulsive or ill-informed trades that are misreading the situation. We’ll explain it more below as we talk about simple moving averages and exponential moving averages.

Simple Moving Averages

One of the most important technical analysis tools in online trading, moving averages are statistics that show the average set of data points over a specified period. Traders can use moving averages to identify trends with stock options, forex, or futures trading. They are calculated by adding up the closing prices of a security and then dividing that sum by the number of periods that the trader is using to determine the average. Periods that can be used include days, weeks, or months.

A good way to look at simple moving averages is that the price of a security is increasing when there is an upward trend in a moving average and that the price is decreasing when a downtrend is present. Moving averages are a great way for traders to make sense of what’s occurring while securing pricing amid the noise of the market. They can pinpoint long-term trends that go a long way toward informing the trading strategy they might want to use.

To find moving averages on a chart, traders can find them above or below the current price. Multiple moving averages can be used on charts, one for each trading strategy being employed.

Exponential Moving Averages

Exponential moving averages are another type of technical indicator that tracks price changes over time. Not only are they great for identifying trends, but they can be used to predict future prices and to put together investment decisions. Being calculated by using multipliers that place more weight on recent price data, exponential moving averages are a “weighted moving average” that places more importance on recent price data than simple moving averages would.

EMAs can be used to identify support and resistance levels in trading. When EMA is on the rise, you’ll see support for the price action, while falling EMA is representative of resistance in the price action. A good rule of thumb for traders using EMA would be to buy when the price is near the rising EMA or to sell when the price is near a falling EMA.

Exponential moving averages can be used in different financial markets like stock options, commodities, or currencies and they’re usually used in conjunction with other technical analysis indicators.

Best Settings for Options Trading

The best settings for trading, using exponential moving averages, are using 9-day and 21-day EMAs, especially for short-term trades. The 9-day EMA is a more fast-paced indicator for pinpointing a trend quickly (identifying price movements and potential trend reversals), while the 21-day EMA is better for getting a broader look at the trend to fully understand what’s going on.

Use the 9-day and 21-day EMAs together to establish any kind of crossover that might be occurring. The best move for a trader to make is rooted in the 9-day EMA crossing above or below the 21-day average. The “buy signal” is when the 9-day EMA crosses above the 21-day average which could indicate a bullish trend shift. The 9-day EMA crossing below is a “sell signal” and indicates to traders that a potential bearish trend shift is underway.

It’s always recommended for short-term traders using EMAs to pair these crossover confirmations with other price action analyses or technical indicators. Traders need to use risk management when necessary too, like stop-losses to mitigate potential risks.

2. Relative Strength Index (RSI)

Relative strength index indicators are used in trading to measure the magnitude and speed of recent price changes in security. Traders can use RSI to identify potential trend reversals based on an analysis of momentum. RSI takes a comparison of recent gains to recent losses to indicate if a security is either overbought or oversold with the values ranging from 0 to 100. If the RSI reading is above 70, the security is considered overbought. RSI readings below 30 are considered oversold. Anything around 50 is considered neutral, meaning that there’s balance pressure between buying and selling securities.

Calculating RSI involves taking the average gains and losses over a set period and turning that comparison into a ratio. It’s typically done in a timeframe of 14 trading days. The exact formula for calculating RSI can be difficult to understand but that’s the basic idea behind the concept. The core idea is that an overbought security has a price that’s too high, and an oversold security has a price that’s too low.

Optimal RSI Settings

As we pointed out above, the optimum RSI settings are the 14-period (14 trading days), but the timeframe can be adjusted based on your trading preferences. For instance, you could make the timeframe for a longer period like 20 or 30 trading days. You could also adjust it down lower to short periods like 5 or 6 days. If you’re looking for a good place to start though, it’s best to begin with the 14 days and see how it goes. You can make adjustments as you learn to use the indicator.

RSI divergences are where the price and the RSI move in the opposite direction, a phenomenon traders can use to pinpoint potential trend reversals. To give you an idea of what we’re referring to, let’s talk about bearish and bullish divergence:

• Bearish Divergence: This is an indication of a potential downtrend as the price makes higher highs, but the relative strength index makes lower highs. The current uptrend could be losing steam, and a potential downtrend could be in the works. When there is a bearish divergence, traders might want to consider taking a short position or exiting a long position.
• Bullish Divergence: This is an indication of a potential uptrend as the price makes lower low,s but the relative strength index makes higher lows. The other side of bearish divergence, bullish divergence, shows that the current downtrend might be weakening and that a new uptrend could be coming soon. Bullish divergence suggests that traders or investors should take long positions while exiting short positions.

As is the case with other technical indicators, the relative strength index should be used with other analysis tools and indicators. By no means should traders use RSI divergence as a guarantee of what they’d like to see. It’s simply used as a signal. It’s key to confirm these trend reversals with other technical indicators and analysis methods. Use risk management techniques like stop-loss orders to minimize potential losses.

3. Bollinger Bands

Another technical analysis tool that’s commonly used by traders is Bollinger Bands which shows the relative high and low prices of a financial instrument over time. Not only can they determine if prices are overbought or oversold (like the relative strength index), but Bollinger Bands can also help traders identify potential trading opportunities as well as potential price reversals, trends, or breakouts.

Bollinger Bands consists of three pieces: the upper, lower, and middle bands:

Upper Band: The price level on a chart where an option is considered overbought, where the value is calculated to signify the potential where the price could reverse or lose momentum, resulting in a slowdown of the current trend. Traders should consider selling the options when the prices reach the upper band. It’s a signal that the rising price is possibly going in the other direction soon.

Lower Band: The price level on a chart where an option is considered oversold, where the value is calculated to signify the potential where the price could reverse or lose momentum, resulting in a slowdown of the current trend. Traders should consider buying the options when the price reaches the lower band. It’s a signal that the falling price is possibly going in the other direction soon.

Middle Band: Located between the upper and lower bands, the middle band represents a simple moving average, which is calculated over 20 days. A baseline for the upper and lower bands, the middle band shows the price trend over that timeframe. It ultimately shows the trader the support and resistance levels.

Bollinger Bands can be used to spot volatility expansion and breakouts. For instance, traders can establish long positions when the price breaks above the upper band or establish short positions when it breaks below the lower band. In terms of expansion, potential breakouts can be indicated through increasing volatility, which occurs when the bands move further apart from one another.

Best Strategy

Using Bollinger Bands squeeze to anticipate big price moves is one of the best strategies for traders to use when looking for buying or selling opportunities. Squeezes or contractions occur when the bands are narrow (indicating low volatility) and these conditions are often followed by a significant price move in either direction. Breakouts occurring above the upper band indicate bullish moves and possible buying opportunities, while breakouts below the lower band indicate bearish moves and possible selling opportunities.

Example

Your best move when it comes to trading options on a stock when the price breaks out of the band all depends on which direction the price movement goes. Prices that break above the upper band after a squeeze are a good signal for traders to enter long positions, while prices that break below the lower band after a squeeze indicate that the trader should enter a short position.

4. MACD (Moving Average Convergence Divergence)

The MACD technical analysis indicated is used to find potential changes in the trend direction of momentum. Traders can figure out if the price trend they’re seeing is gaining or losing strength based on the relationship between the moving averages. MACD is calculated by comparing two exponential moving averages—convergence is where the averages come closer together, and divergence is where the averages move further apart.

MACD comes with three main components: the MACD line, the signal line, and the histogram. The MACD line is determined by subtracting the long-term EMA (exponential moving average) from the short-term EMA. The signal line is calculated using a 9-day EMA and represents the moving average of the MACD line. The histogram is a visual representation of the differences between the signal line and the MACD line.

MACD helps identify trend strength and direction, especially when there are crossovers between the MACD and signal lines. MACD lines crossing above signal lines indicate a bullish signal, while the MACD line crossing below the signal line can be an indication of a potential bearish signal.

Best Strategy

Using MACD crossovers for entry or exit signals in options trades begins with looking for potential trend changes. We already talked about the MACD line crossing above or below the signal line and how it can signal a bullish or bearish trend, so let’s talk about the ideal entry and exit points based on the current trends and signals:

• Entry Signals: Enter a call option trade when the MACD line crosses above the signal line (bullish signal indicating an uptrend). Enter a put option trade when the MACD line crosses below the signal line (bearish signal indicating a downtrend).
• Exit Signals: Exit a call option trade when the MACD line crosses below the signal line (bullish signal indicating a downtrend). Exit a put option trade when the MACD line crosses above the signal line (bearish signal indicating an uptrend).

5. Implied Volatility (IV) and the IV Rank

Two other excellent technical indicators are implied volatility and IV rank. They’re best used hand-in-hand alongside other technical indicators to find crossover confirmation.

Implied Volatility

Implied volatility is a technical indicator and forward-looking estimate of how much a stock’s price might fluctuate in the future. Being a subjective measure, implied volatility is different from historical volatility (based on past price movements). Implied volatility or IV can be calculated using an option pricing model and it can predict the magnitude of price swings, but not direction. Higher implied volatility leads to higher options prices. It tends to increase in bearish markets and decrease in bullish markets.

IV Rank

Implied volatility rank is a tool that compares the current implied volatility of a security to its historic range. Traders can use this tool to determine if the current implied volatility is high or low. The IV rank is calculated through a collection of historical IV data where each security gets assigned a rank from 0 to 100 (0 is the lowest IV and 100 is the highest IV) based on the relationship between the current IV and its historical IVs. IV rank can help traders find ideal buying and selling opportunities where they should sell when IV is high or buy when IV is low.

Best Strategy

It’s no secret that traders should sell options when the price is high and buy options when the price is low. Using implied volatility is a great indicator of what the best action is that a trader can take based on the current conditions. Selling options are best when the IV is high, and buying options are ideal when the IV is low. A good example of using implied volatility to inform your trading decisions would be a trader selling credit spreads when IV is elevated for better premiums.

6. Volume and Open Interest

Two other strong technical indicators include volume and open interest. Both offer valuable insights into market trends and the strength behind them. Traders can discover if the trend is bound to continue or if a trend reversal is imminent.

• Volume: The number of contracts traded during a specific period (typically during a single trading day). The higher the volume, the stronger the market activity and interest in a certain security or a type of contract. Higher volume can confirm price trends where it can indicate if particular price movements are supported either by strong selling or buying pressure. Higher volume is also a good indicator of better liquidity, meaning that it’s easier to enter or exit those positions quickly.
• Open Interest: The total number of outstanding contracts that haven’t been closed or settled. These contracts are still active and they haven’t been closed or settled through assignment, exercise, or expiration. Strong upward trends can be pinpointed by rising prices that are present alongside increasing open interest, while strong downward trends are the result of a rising market paired with decreasing open interest. High open interest is also an indicator of a more liquid market where contracts can be bought or sold quickly and easily.

Not only are volume and open interest important in options trading from the standpoint of finding contracts that are liquid and have either significant buying or selling pressure, but these are great tools for spotting unusual options activity which can be the earmarks of potential big moves. When there are significant deviations in trading volume or open interest, you have unusual options activity which could be a sign of large market movements or insider knowledge of trends that aren’t readily apparent to the general trading public.

You can see unusual options activity in the following occurrences:

• A surge in the number of contracts traded compared to the average (higher volume)
• A major increase or decrease in the number of outstanding options contracts at a certain strike price

7. VWAP (Volume Weighted Average Price)

VWAP stands for volume-weighted average price and it’s a technical analysis tool that shows the average stock price through the trading day. VWAP is calculated by weighing the price of each share by the number of shares traded at that price. VWAP is especially popular with intraday options traders—it helps traders understand the average price at which a stock has traded throughout the day, based on volume and price.

Professional traders use VWAP as a benchmark. It lets traders establish intraday support and resistance levels as well as compare trade execution quality. Through the integration of both price and volume, volume-weighted average price helps these investors find the best entry and exit points for each trade they conduct. VWAP is not only a terrific benchmark, but it also influences price action throughout the day.

Best Strategy

The best course of action for traders who want to integrate this technical indicator into their trading routine is to buy calls when the price is above VWAP and to buy puts when the price is below VWAP.

• Buying Calls: The price being above VWAP suggests that a bullish trend could be underway. Buyers might be more open to paying a premium due to signals that upward momentum is likely possible. Under these conditions, traders might have the best success with buying call options.
• Buying Puts: The price being below VWAP suggests a bearish trend could be underway. It’s an indication that the price is expected to fall further (the current price is below the average price weighted by volume). Under these circumstances, traders should load up on put options to deal with the price decline.

Example

In options scalping, volume-weighted average price can be used by traders to pinpoint support and resistance levels, which can help them to find the ideal entry or exit points. VWAP is a great benchmark for fair market value, and it’s a great tool for intraday analysis, which comes in handy when scalping. Using VWAP as support/resistance in options scalping can lead to better trade execution and entering or exiting trades at the appropriate times.

8. ATR (Average True Range) for Volatility Measurement

Another prominent technical analysis tool is the average true range, which measures how much an asset’s price might fluctuate over time. It’s a great measure that traders use to assess volatility and to make the best possible trading decisions based on the current market conditions.

The average true range or ATR is calculated by averaging the true range or the maximum of the absolute values of the current high minus the current low, the current low minus the previous close, and the current high minus the previous close. Averaging the true range is done over a specified period and is usually calculated based on 14 periods, though traders can technically use shorter or longer periods based on their trading style.

Traders can use ATR to set stop losses or manage risk and even to determine when the right time is to execute certain trades. A higher ATR usually points toward greater volatility, while a lower ATR points to lower volatility. Not only does a higher average true range indicate greater volatility, but so does an expanding average true range. Another important indication is a reversal in price with an increasing ATR which generally points toward strength.

Best Strategy

The best way to use the average true range to your advantage would be to adjust position sizing based on ATR. Traders can dynamically scale their investments to match the current volatility seen in the market. The result is that traders should take on smaller positions when there are higher ATR values (greater volatility) or take on larger positions when there are lower ATR values.

When it comes to calculating your position, you can do so based on stop-loss or risk per unit. For the first method, a trader could use a stop-loss which is based on a multiplier of the average true range. They can then determine the position size based on the amount they’re willing to risk. The other method involves calculating the risk per unit (based on ATR) and then dividing that risk by the risk per unit.

How to Combine Indicators for Maximum Effectiveness

We cannot emphasize enough the need for online traders to combine multiple technical indicators for the best possible outcome. Because markets are influenced by various factors and can be complex by nature, traders need to recognize that no single indicator is foolproof and that multiple indicators need to be paired together to avoid things like limited accuracy in assessing trending markets or potential false signals.

Indicator Combinations That Work Well Together

• EMA + RSI + MACD for Trend Confirmation: The combination of these three indicators aims to enhance the accuracy and reliability of trading signals. It takes a look at emerging trends from multiple perspectives, which in turn reduces the risk of false judgments. This approach is a nice balance between trend following and successfully navigating trend reversals. Using exponential moving averages and moving average convergence and divergence, in particular, let traders capture trends while also offering time indications on possible trend reversals.
• Bollinger Bands + ATR for Volatility Breakout Trades: The combination of using the Average True Range for market volatility and Bollinger Bands for price volatility can help traders confirm breakout patterns and effectively manage risk. Use the Bollinger Bands to find the “squeeze” where a breakout is likely to occur, then observe the ATR value at the point of the breakout. If the ATR is increasing during the breakout is a confirmation that volatility is rising. This supports the likelihood of a sustained move.
• VWAP + Volume for Institutional Trade Confirmation: Use this technical indicator combination to confirm trade execution quality. Minimize market impact or potential losses using this combination to ensure that large orders are executed at or near the market’s average price.

Common Mistakes Traders Make When Using Indicators

Technical indicators are helpful, robust trading tools that can do a lot of good for online traders and investors when it comes to predicting future price movements and analyzing market trends. However, there are some major mistakes that traders can make when using technical indicators, so we’ve compiled a list of these common mistakes to show you how to use them properly and not fall into these traps.

Overloading Charts with Too Many Indicators

The big mistakes that traders make when they do this are making it difficult to identify key signals and, therefore, make the best-informed decisions. Too many indicators at one given time can lead to paralysis when it comes to performing a good analysis or even taking the first step in the ensuing strategy. It can also lead to confusion as to how to proceed with the trade.

The other big mistake here is focusing on quantity over quality. Having too many different research, voices, and opinions informing your trading decisions can play on your emotions (one of the last things you want to experience while trading options), so it’s best to limit your charts to only the most relevant news. Instead, traders should focus on only a few reliable indicators that complement one another well and don’t lead to confusion.

Relying Solely on Indicators without Considering Market Conditions

Ignoring market conditions and relying only on the technical indicators can lead traders to miss the greater context completely and take false signals to confirm what the next best move might be. Looking only at indicators to inform your trading decisions doesn’t consider market sentiment or fundamental factors which can lead to traders missing out on the most comprehensive analysis of the current market situation.

Ignoring Risk Management and Trading Psychology

No matter what kind of technical analysis you might be using to determine your next move in online trading, it’s best to always use risk management, no matter how good the signs might look for you when you’re looking over Bollinger Bands, the Relative Strength Index, Moving Averages, or any other technical analysis tool you prefer. Use correct position sizing and use stop-loss orders to minimize potential risks; otherwise, you could lose a lot of money unnecessarily because you’re putting too much faith into technical analysis.

Risk management is essential for protecting your capital and preserving your overall profitability. A sound risk management plan is also good when it comes to long-term sustainability in trading, and it can help traders to avoid trading based on emotions like greed, frustration, or overconfidence. The consequences of ignoring risk management include incurring significant (and unnecessary) losses, emotional distress due to instability, unrealistic expectations, and burnout, which spells doom for traders.

Not Backtesting Strategies before Live Trading

It’s always best to test out your trading strategies using paper trading, trade simulators, or demo accounts before you try your hand at using them in the live trading environment using real money. Those who don’t take the time to test strategies through backtesting could be putting their capital at risk when they could have taken the time to practice the trading techniques beforehand.

Pro Tips for Using Indicators in Options Trading

• Adjust Indicator Settings Based on Timeframes: Longer timeframes provide a broader understanding of the overall direction of the market and current trends, while shorter timeframes allow traders to focus on short-term price movements where they can identify potential entry or exit points that are appropriate for the broader trend. (intraday vs. swing trading).
• Pay Attention to Overall Market Trends and News Events: The best traders use a wide range of sources to keep an eye on relevant market trends and news developments. News websites, tickers, and aggregators are some great ways to get started with keeping informed. The most relevant trading or investment stories can be accessed on news coverage websites like BBC, The New York Times, The Globe, or Reuters, while aggregators like AP News or Google News can organize financial data or news from various sources.

Podcasts and social media are helpful tools as well where you can hear voices from industry experts or seasoned traders who want to share their knowledge or experiences with listeners or viewers. Another great way to keep on top of relevant news is to have customized alerts on your computer or mobile device that keep you in the know with any sort of major developments in the broader market.

• Use Paper Trading or a Demo Account to Test Strategies: Don’t test out your strategies in a live market setting, but instead backtest them using a demo account or a paper trading simulator to see how viable they might be. If you’re not super familiar with using technical indicators, using these tools can help you get an idea of what to expect, and you can do it without putting any of your own money at risk, just your virtual balance.
• Keep a Trading Journal to Track Indicator Performance: By keeping a trading journal and tracking everything that occurs during your live trading sessions, you can look back on what worked and didn’t work while using technical indicators as a guide. Being able to look back over your history of trading can give you key insights into which moves you’ll want to keep using in certain scenarios and the moves that would be best substituted by an approach that works better.

Master These Indicators & Trade Options Like a Pro!

Technical indicators are a great tool for traders to analyze current market trends, find the best trading opportunities, and navigate the risks that come with any trade like a champ. Whether you’re using Bollinger Bands, the Relative Strength Index, or Open Interest/Volume, it’s best to use a combination of the best indicators to crosscheck your research to get an accurate read on the market.

If you’re new to using technical indicators, it’s best to test out your trading strategies using demo accounts or paper trading simulators that might be offered on the online options broker of choice. As you experiment with using indicators and implementing the suggested strategies, you can begin transitioning from a demo account environment to a live trading environment, so you can go into those situations well-prepared.

Start using these indicators today and trade options like a pro!