Best technical indicator option trading

Best Technical Indicators for Day Trading.

With loads of technical indicators, here's how to narrow it down to a few.

The MACD, RSI, moving average, Bollinger Bands, stochastics, and the list goes on, but what are the best technical indicators for day trading? Day traders need to act quickly, so trying to monitor too many indicators becomes time consuming, counter productive and is actually likely to deteriorate performance. When day trading--whether stocks, forex or futures--keep it simple. Use only a couple indicators, maximum, or not using any is fine too.

Consider these tips to find the best day trading indicator(s) for you.

Day Trading with Indicators or No Indicators.

Indicators are just manipulations of price data or volume data, therefore many day traders don't use indicators at all. Indicators aren't required for profitable trading. Practice trading based on price action and there is little need for indicators. That said, an indicator does help some people see things that may not be obvious on the price chart. For example, the price is trending higher, but it is losing momentum. To someone not used to reading price action (analyzing how the price is moving) this may be hard to see, but indicators can make it more obvious. Unfortunately, indicators come with their own sets of problems, signaling a reversal too soon or too late (see Don't Trade MACD Divergence Until You Read This).

Indicators aren't inherently bad or good, they are just a tool and therefore whether they are detrimental or helpful depends on how they are used.

Many Trading Indicators are Redundant.

Many indicators are almost exactly the same, with slight variations. One may be based on percent movements while another is based on dollar movement (PPO and MACD). Also, indicators may be part of the same "family." Examples of this include the MACD, stochastics and RSI.

While they may appear slightly different, usually just using one is enough. Having all three on your chart isn't going to improve the odds of your trades, because all these indicators are going to give you pretty much the same information most of the time.

Even a moving average (MA) and a MACD can give the same information. If you use a MACD (12,26) indicator and also add 12 and 26-period MAs to your price chart, the MACD indicator and MAs will tell you the same thing. In fact, all the MACD does is show how far the 12-period moving average is above or below the 26 period moving average. When the MACD crosses above or below the zero the line, that means the 12-period moving average crossed above or below the 26-period. If you added these indicators to your chart they would always confirm each other, because they are using the same input.

If you opt to use indicators, only pick one from each of the following four groups (if required, remember indicators aren't need to trade profitably). Even picking only one from each group could lead to redundancies and clutter, without providing additional insight.

Oscillators: This is a group of indicators that flow up and down, often between upper and lower bounds. Popular oscillators include the RSI, Stochastics, Commodity Channel Index (CCI) and MACD.

Volume: Aside from basic volume, there are also volume indicators. These typically combine volume with price data in an attempt to determine how strong a price trend is. Popular volume indicators include Volume (plain), Chaikin Money Flow, On Balance Volume and Money Flow. Overlays : These are indicators that overlap the price movement, unlike a MACD indicator for instance which is separate from the price chart. With overlays you may choose to use more than one, since their functions are so varied. Popular overlays include Bollinger Bands, Keltner Channels, Parabolic SAR, Moving Averages, Pivot Points and Fibonacci Extensions and Retracements. Breadth Indicators : This group includes any indicators that has to do with trader sentiment or what the broader market is doing. These are mostly stock market related, and include Trin, Ticks, Tiki and the Advance-Decline Line.

There is little need for more than one oscillator, breadth or volume indicator. You may find uses for a few overlays though, helping to indicate trend changes, trade levels and areas of potential support or resistance. Master using price action and overlays and you likely won't have need for the other types of indicators.

Combining Day Trading Indicators.

Consider picking picking one or two indicators to help with entries and exits, respectively. For example, an RSI could be used to help isolate the trend and entry points. In an uptrend, the RSI should be extending above 70 on rallies and staying above 30 on pullbacks. This simple guide can help confirm the trend, highlight trading opportunities, and see when the market may be changing trend direction.

A moving average, ATR Stops (Chandelier Exits) or Moving Average Envelopes could then be applied to the chart (overlays) to aid in exits. For example, one of these could be used as a trailing stock loss on trending trades. If the trend is up, look to exit if the price falls below the line (which will be below the price as the price rises).

This is just one example of how indicators can be combined. Which indicators are chosen depends on how a trader trades, and on what time frame. Calibrate each indicator (via the indicator settings) to the specific assets, time frame and strategy being traded. Default setting on the indicator may not be ideal, so alter them to make sure they give the best signals for the trades being taken. Indicator settings may require adjustments occasionally as market conditions change over time.

Final Word On the Best Indicator for Day Trading.

Unfortunately, there is no single indicator that is the best for day trading. Technical indicators are just tools, they can't produce profits. Profits require a trader to use their indicators and price analysis skills in the correct way (see Day trading False Breakouts). This takes practice. Whatever indicators you decide to use, limit it to one to three (or even zero is fine). Using more indicators is redundant and could actually lead to worse performance.

Know your indicator(s) well: What are its drawbacks? When does it typically produce false signals? What good trades does it miss (failure to signal)? Does it tend to give signals too early or too late? Can the indicator be used to trigger a trade, or does it just alert you too a potential trade (good timing or poor timing)?

Know those things about the indicators you use, and you will be on your way to using it more productively.

The Top Technical Indicators For Options Trading.

There are hundreds of technical indicators available which are used by traders according to their style of trading and securities to be traded. This article focuses on a few important technical indicators specific to options trading. (Confused? If you are not sure that technical trading or options is for you, check out or tutorial, Introduction to Stock Trader Types, to decide your preferred style.)

This article assumes familiarity of the reader with options terminology and calculations involved in technical indicators.

How option trading is different.

Usually, technical indicators are used for short term trading. Compared to a typical stock trader, an option trader looks for additional aspects of trading:

Range of movement (How much - volatility), Direction of the move (Which way) and Duration of the move (How long - time)

Since options are decaying assets (see time decay of options), the holding period takes significance for options trading. A stock trader has the liberty to hold the position indefinitely or even convert the short term margin leveraged position into a cash based holding. But an option trader is constrained by the limited duration due to the option expiry date where there is no choice to hold an option position indefinitely. It hence becomes important to select the correct trading strategies taking into consideration the timing factor.

Due to the above constraints, almost all of the technical indicators suitable for options trading are momentum indicators, which tend to identify overbought and oversold markets, and hence price reversals and related trends.

The following technical indicators are commonly used for options trading:

A technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.

How is RSI useful for option trading?

RSI attempts to determine overbought and oversold conditions of a security. It thereby provides vital indications about the short term price moves, or rather corrections and reversals, once the overbought or oversold condition is identified.

RSI works best for options on individual stocks (instead of indexes), as stocks demonstrate the overbought and oversold condition more frequently as compared to indexes. Options on highly liquid high beta stocks make the best candidates for short term trading based on RSI. (Check out Investopedia’s detailed article on RSI with examples)

As standard parameters commonly followed, RSI values range from 0-100. A value above 70 indicates overbought levels, and that below 30 indicates oversold.

All options traders are aware of the importance of volatility on options valuation. Bollinger bands capture this aspect of an underlying security, allowing upper and lower ranges to be identified within dynamically generated bands based on recent price moves of the security.

Two important indications which are derived from Bollinger Bands:

The bands expand and contract as volatility increases or decreases based on the recent price movement of the stock (expansion indicates high volatility and contraction indicate low volatility). The trader can thus take option positions expecting a reversal. The current market price can be assessed against the current band range for any breakout patterns. Breakout above top band indicates overbought market, which is ideal indication for buying puts or shorting calls. Breakout below lower band indicates oversold market – an opportunity to buy calls or short puts at lower volatility. Care should be taken to assess volatility – shorting options at high volatility is beneficial, as it gives higher premiums to the trader, while buying options at lower volatility provides cheaper options.

Traders are free to use their own desired values while looking at Bollinger bands. Commonly followed values are 12 for simple moving average and 2 for standard deviation for top and bottom bands.

For high frequency options traders, the IMI indicator offers a good choice of technical indicator to bet on intraday option trades. It combines the concepts of intraday candlesticks and RSI, thereby providing a suitable range (similar to RSI) for intraday trading by indicating overbought and oversold markets. However, it is important to additionally be aware about the “trendiness” of the price moves, because when there is a strong visible up/down trend, the momentum indicators will frequently show overbought/oversold opportunities. Being aware of the trends, and additionally using IMI, a trader can spot potentials where he can get into a long position in an uptrending market at intermediate intraday corrections and short positions in a downtrend market at intermediate price bumps.

IMI is calculated as follows:

1. If Close > Open: Gains = Gain (n-1) + (Close - Open); Losses = 0.

2. If Close < Open: Losses = Loss (n-1) + (Open - Close); Gains = 0.

3. Add Gains and Losses for past n chosen periods.

4. IMI = 100 x (Gains / (Gains + Losses))

Taking benefits of leverage with option positions, the IMI indicator (combined with a suitable trend following indicator) offers a great technical indicator for options trading.

The formula offers flexibility to traders to use their own desired values for n. Commonly followed resultant values are 70 or higher indicating overbought markets, and 30 or below indicating oversold markets. The interpretation remains similar to RSI discussed above.

Adding further to the RSI basket, the MFI is another momentum indicator that combines the price and volume data to identify price trends for a stock. It is also known as volume-weighted RSI.

With volume considered into calculations, the MFI indicator provides vital inputs about the amount of capital flowing in and out of a stock over a recent time period (recommended 14 days).

Due to dependency on volume data, MFI indicator is suited for stock based options trading (instead of index based), and fairs better for long duration option trading instead of frequent intraday. Traders look for cases when MFI indicator moves in opposite direction to that of stock price, as this can be a leading indicator to predict a trend reversal.

Commonly followed resultant values for the Money Flow Index are 20 indicating oversold and 80 indicating Overbought.

The put call ratio indicates the ratio of trading volume of put options to call options. Instead of the absolute value of the Put Call ratio, the changes in its value indicate a change in overall market sentiment.

A high to lower value move indicates a bullish trend, indicating more calls being opted for by the traders, while a low to high value move indicates bearish trend as more puts are of interest in the market.

Open interest indicate the open or unsettled contracts in options. OI does not necessarily indicate any specific uptrend or downtrend, but it does provide indications about the end of a particular trend. Increasing open interest indicates new capital inflow and hence sustainability of the existing up or down trend, while declining open interest indicates an end to the trend.

For options trading where traders look to benefit from short term price moves and trends, OI provides important information beneficial for entering into or squaring off option positions.

OI values, in addition to the traded volume and price movements, are frequently used by option traders. Here is an indicative interpretation for OI and price moves:

Market is Strong.

Market is Weakening.

Market is Strengthening.

In addition to the above mentioned technical indicators, there are hundreds of other indicators which can be used for trading options (like Stochastic Oscillators, Average True Range, Cumulative tick, moving averages, etc). On top of those, a lot of variations exist with smoothening techniques on resultant values, averaging principals and usage of combinations of various indicators. An option trader should select the one suiting his or her own trading style and strategy, after carefully examining the mathematical dependencies and calculations.

Using Technical Indicators.

Technical indicators can be used to help you enter and exit trades.

They assist you in predicting the future with a fair amount of accuracy, and are very instrumental in maximizing trading profits and minimizing losses.

Technical indicators are a good supplement to your use of technical analysis.

As we learned in one of the previous modules, technical analysis is the formal name for analyzing stock charts.

The basic premise is that you look at past price behavior in an attempt to determine where prices are headed in the future.

Consider it like predicting the weather. It doesn't guarantee what is "going" to happen, but it merely guides you in preparing for what is "likely" to happen .

Pretend that the price movement on the chart is the actual weather. Technical indicators would be the weather satellites that aid you in predicting the weather.

A weather satellite (technical indicator) can warn you that a storm is coming (prices are going to fall) so that you can prepare for it accordingly (protect profits or enter a new trade).

What are Technical Indicators?

Technical indicators are mathematical representations of market patterns and behavior; or in my wife's terms, "it's all those squiggly lines going all over the place" .

The indicators are formed by plugging information such as price and volume into a mathematical formula. The formula produces a data point. Several data points are collected over a period of time and are usually connected by a thin line.

The blue arrows on the chart below point to the three technical indicators. As you look at the chart see if you can point out the 4 keys areas that we discussed in Module 4:

Technical indicators can be found above or below the chart, and others are plotted on top of prices. The indicators help to predict where future prices are going and whether or not the stock is in an overbought or oversold condition.

Overbought: A technical condition that occurs when there has been a lot of buying and the price of the stock is considered too high and susceptible to a decline.

Oversold: A technical condition that occurs when there has been a lot of selling and the price of the stock is considered too low and a rally in prices is anticipated.

Essentially traders use technical indicators for two things:

To generate buy and sell signals To confirm price movement.

There are two main types of indicators: leading and lagging.

Leading Indicators.

A leading indicator precedes price movement, and is often used to generate buy and sell signals. Most represent some form of price momentum over a given period of time.

Leading indicators are affected more heavily by recent price changes and tend to generate more signals and allow more opportunities to trade than lagging indicators.

Since the indicators produce more buy and sell signals, they also produce more false signals.

Some of the more common leading indicators are:

When leading indicators are right, they allow you to get into a trade early and make more money, but when they're wrong you tend to lose money because you're in and out of trades more frequently.

What you think will happen doesn't actually happen. This is where lagging indicators come into play.

Lagging Indicators.

A lagging indicator is a confirmation tool because it follows price movement. It happens "after the fact".

So after prices have been trending for some time the lagging indicator will then produce a signal that the trend is changing. It solidifies and is a final confirmation that indeed the trend is changing.

Two of the more common lagging indicators are:

The Holy Grail of Technical Indicators.

I don't care what technical indicator you use, price and volume will always win the day.

Think about it, technical indicators are nothing but mathematical formulas with data plugged into them. What is the primary source of data plugged into them?

That's right, price and volume.

The formulas can be manipulated, but the actual price and volume is created by real people buying and selling the stock.

At the end of the day, buyers and sellers are what control and move the market.

My technical indicator could tell me that tomorrow the stock is going up, but if tomorrow sellers rule the day and the stock falls then essentially their actions rendered my indicator useless.

Use the indicators as a supplement to your trading and to assist you in seeing price action more clearly. Do not treat them as if they are the law!

Final Thoughts.

Sometimes it's not clear what is going on by merely looking at the chart and this is where a technical indicator comes into play.

For example, the flat area on the chart below may seem insignificant, but as I look at Williams %R I can see there was heavy buying (overbought) in this area:

Remember the definition of overbought above: A technical condition that occurs when there has been a lot of buying and the price of the stock is considered too high and susceptible to a decline .

And what do you know, prices did indeed fall right after the overbought signal.

I was so hung up on oversold and overbought when I first learned how to trade. For the life of me I couldn't figure out how a lot of buying could cause a stock to fall in price.

It's so counter-intuitive.

It will take some time, but the more you learn about the stock market the more it will make sense.

Each indicator has its own unique purpose. Grouping indicators that complement each other can create a powerful winning combination.

One simple combination that I use frequently is combining a leading indicator with a lagging indicator.

You don't want two indicators on a chart that are essentially the same. For example, don't have two indicators that both measure volume.

Often I encounter traders that will have as many as 12 indicators on a chart. In my opinion this just confuses people more. This is my belief and it certainly is not the belief of all, but more is NOT better. Clean and simple wins the day for me.

The more indicators I place on a chart, the more my eyes start to spin and I get dizzy by all the zig zag lines going all over the place. Besides, it takes your attention away from what really matters…price and volume.

Lesson Review.

Technical Indicators are like weather forecasting. They don't guarantee what is "going" to happen, but merely guide you in preparing for what is "likely" to happen.

There are two kinds of indicators:

Leading (Stochastics, Williams %R, Relative Strength Index, etc.): generally precedes price movement, and is often used to generate buy and sell signals. More heavily affected by recent price changes Lagging (MACD, Moving Averages, etc.): is a confirmation tool because it follows price movement. It happens "after the fact".

Overbought: A technical condition that occurs when there has been a lot of buying and the price of the stock is considered too high and susceptible to a decline.

Oversold: A technical condition that occurs when there has been a lot of selling and the price of the stock is considered too low and a rally in prices is anticipated.

Grouping indicators that complement each other can create a powerful winning combination.

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Technical Indicators.

As the name suggests, Technical Indicators are used to indicate trends and possible turning points in stock prices. These are the tools used by Technical Analysts to predict cycles, and to predict when is the best time to buy or sell a stock or option.

Technical Indicators are calculated based on a particular stock or derivative's price pattern. Data such as opening price , closing price , highs , lows , as well as the volume , are used to create the many technical indicators out there. The indicators generally take the stock's price data from the last few periods (for example the last 30 days). They use that data to create a trend or chart to indicate what has been happening to the stock, and hopefully predict what may happen in the future.

There are two main types of indicators: Leading Indicators and Lagging Indicators . Lagging Indicators are indicators which follow the stock's price pattern, hence the name "Lagging" Indicators. Since they are based on past data, they are good in showing whether a trend is developing, or whether at stock is in a trading range (ie. trading sideways). For example, lagging indicators can show that a stock has developed a very strong downtrend, and is therefore likely to continue falling.

On the other hand, Lagging Indicators are not good when predicting future rallies or pullbacks. They can show what trends have developed until the current point, but are not able to predict the next few days' movement. Examples of Lagging Indicators include trending indicators such as the Moving Average, MACD and ADX indicators, which we cover in this guide.

On the other hand, Leading Indicators , as the name implies, are better at predicting possible future price rallies and crashes. Most Leading Indicators are momentum indicators, gauging the momentum of a stock price's movements.

Imagine a football we are throwing up in the air. Common sense indicates that the football cannot keep going higher forever. We might not know how high it will go, but we do know that once its upward speed starts to slow down, it will soon stop going up and start falling down again. That is the basis of momentum indicators.

Leading Indicators are good at telling us whether a stock's price has gone too high up or too far down, and whether there is a slowdown in price movement. If the stock's price has gone too high up, we say that the stock is now overbought . If the price has gone too far down, we say it is oversold . In either case, the leading indicators will show that the stock will not remain overbought or oversold for long. A pullback is imminent. Examples of Leading Indicators include the RSI, as well as other momentum indicators.

Both Leading and Lagging Indicators are equally important. We need to know both the trends that are developing as well as possible slowdowns and price pullbacks. In fact, investors are advised not to base their decisions on just one indicator. After all, no indicator is perfect. All indicators can produce false signals from time to time. Therefore, it is recommended that investors take 2 or 3 indicators they are comfortable with, and base their decisions on them (ie. only buy when all 3 indicators tell you to buy).

There are hundreds of indicators in use at the moment. In fact, any high-profile stock market guru will most likely have developed his own indicator to predict the market. However, in this guide we will only cover 5 indicators, which are based on different data and serve different functions. In doing so we hope to expose you to the various types of indicators out there, and enable you to choose which type of indicator you are more comfortable with.

Other Topics in this Guide.

Other Topics in this Guide.

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