Best Indicator for Option Trading – Proven And Successful

To earn a profit in option trading, just guessing is not enough; you have to use the right tools. Indicators are such tools that help in understanding the trend, momentum, and volatility of the market. But the question is: "Which is the best indicator for option trading?"

If you are a beginner and confused about which indicator to use, or an experienced trader who wants to improve their strategy, then this blog is for you. Here, we will talk about the most successful indicators for option trading, from beginner to advanced level. So let's start!

What Are Indicators in the Stock Market?

Trading indicators are mathematical calculations that provide a structured analysis of the market using historical price data and volume. These indicators tell traders whether the trend is bullish or bearish, market momentum is strong or weak, and volatility is high or low.

In simple terms, indicators are like road signs that tell the direction the market might move in. Just like a driver understands what might happen next by looking at road signs and traffic signals, a trader can make informed decisions by using indicators.

How Do Option Trading Indicators Help in Market Analysis?

• Identifying trends: Moving averages and super trends show the trend of the market (uptrend, downtrend, or sideways).

• Measuring volatility: ATR (Average True Range) and IV (Implied Volatility) show market fluctuations and potential price movements.

• Analyzing momentum: RSI (Relative Strength Index) and MACD (Moving Average Convergence Divergence) show whether a stock is overbought or oversold.

Why Are Option Trading Indicators Important?

Option trading indicators play a crucial role in helping traders make informed decisions. They assist in analyzing market behavior and improving the timing of trades in several ways:

• Understanding market trends: These indicators help in telling whether the market is going up or down.

• Measuring volatility: By knowing how fast or slow the market is moving, you can understand how much risk there is.

• Identifying entry and exit points: Indicators tell when to buy and when to sell stocks, so that you can make a decision at the right time.

What Are the Types of Indicators for Option Trading?

There are many types of indicators for option trading in the market, but broadly they fall into 3 categories :

1) Trend Indicators: These tell whether the market is in an uptrend or a downtrend. (Ex: Moving Averages, Supertrend)

2) Momentum Indicators: These tell how much strength is there in the price movement. (Ex: RSI, MACD)

3) Volatility Indicators: These measure whether the market is bullish or bearish. (Ex: Bollinger Bands, ATR)

List of Best Indicators for Options Trading

Here’s a list of top indicators for options trading, based on the trader’s skill level:

Overview of Top Option Trading Indicators - Beginners Level

While option selling requires significant capital and experience due to its high risk and margin requirements, option buying is relatively simpler and more beginner-friendly. Since the capital needed is lower and the risk is limited, buyers can profit as long as they can capture the trend and factors in the Options Greeks in the underlying asset. Let’s now explore some of the best indicators for option trading that can help identify such trends for successful trades.

1) Moving Averages (MA) – SMA & EMA

Moving Averages are one of the best indicators for option trading for trend-following, as they create a smooth line based on the past prices of a security. It helps traders understand long-term and short-term trends. Simple Moving Average (SMA) and Exponential Moving Average (EMA) are very popular indicators for market analysis. SMA is a fixed period average that gives a slow reaction to price fluctuations and is suitable for a longer time frame. While EMA reacts fast to new price movements and is more suitable for a shorter time frame.

The moving average line further varies based on the number of candles used in its calculation, such as 5 MA, 9 MA, 21 MA, 50 MA, and 200 MA. Lower values respond quickly to price changes and are used for short-term analysis, while higher values react more slowly and are suited for long-term trends.

Furthermore, these different period moving averages can be used in combination with one another to identify trends in security. Let us now look at how we can use the combination of 21 MA and 50 MA to identify trends in security.

Entry, Exit, and Stop-Loss: If the 21-day MA crosses above the 50-day MA, it is considered a bullish signal. In this case, traders can look to buy a Call Option. The best time to enter is when the price breaks the recent high and trades above both moving averages, confirming upward momentum. A safe stop-loss can be placed below the recent swing low or the 50-day MA. Profits can be booked near key resistance levels, previous swing highs, or when the price starts closing below the 21-day MA.

If the 21-day MA crosses below the 50-day MA and the price closes below both MAs, it signals a bearish trend. Traders can consider buying a Put Option or taking a short position. The stop-loss can be placed above the recent swing high or just above the 50-day MA. Profits can be booked near key support levels, previous swing lows, or when the price starts closing above the 21-day MA.

Example – SBI CARD Stock:

If SBI CARD stock is trading at Rs 856 and the 21-day EMA crosses above the 50-day EMA, then it is a bullish signal. This means that the price has a chance of increasing further.

2) MACD (Moving Average Convergence Divergence)

MACD is a trend-following and momentum indicator that helps to understand the strength and direction of price movements. It is a combination of two moving averages that creates a MACD line and a signal line. When these two lines cross each other, a trend reversal signal is received.

The main structure of MACD is made up of 3 components:

• MACD Line: (difference of 12-day EMA – 26-day EMA)

• Signal Line: 9-day EMA that is plotted above the MACD line

• Histogram: shows the difference between the MACD and the signal line, which indicates the strength of the trend.

Entry, Exit, and Stop-Loss: If the MACD line crosses above the Signal line and the Histogram turns positive, it indicates a bullish signal. This suggests rising buying momentum, and traders may consider taking a long position or buying call options. A suitable stop-loss can be placed just below the recent swing low to manage risk.

If the MACD line crosses below the Signal line and the Histogram turns negative, it indicates a bearish signal, suggesting increasing selling pressure. Traders can consider shorting or buying put options. In this case, the stop-loss can be placed just above the recent swing high.

MACD is not always accurate: MACD can sometimes give false signals. In a sideways market, MACD can be unreliable as it gives frequent crossovers, which can create whipsaw movements. Therefore, it is important to confirm MACD by combining it with RSI, Volume, and Support-Resistance levels to increase accuracy and avoid false signals.

Example – Tata Motors Stock :

If the MACD bullish crossover is visible on the Tata Motors chart, the price has reversed in the upward direction.

3) VWAP (Volume Weighted Average Price)

VWAP is one of the top option trading indicators; it takes the combination of price and volume to give the actual average price of the market. It acts as a benchmark price for institutional traders and large investors. Traders using VWAP are able to understand momentum and price trends in the market and make better entry-exit decisions.

The VWAP indicator is a single dynamic line that updates based on intraday price movements. When the market price is above the VWAP, it means buyers are dominating and the market is bullish. If the price is below the VWAP, it means sellers are dominating and bearish sentiment is strong.

Entry, Exit, and Stop-Loss: If the price opens below the VWAP and then breaks above it, it can be considered a bullish signal. In this case, traders can consider buying a Call Option when the price sustains above the VWAP with supporting volume. A safe stop-loss can be placed at the recent low below the VWAP. For exit, a good target is when the price approaches the previous day’s high or a strong resistance level.

Conversely, if the price opens above the VWAP and then breaks below it, it signals a bearish setup. The best time to buy a Put Option or consider short-selling is when the price sustains below the VWAP with strong selling volume. The stop-loss in this case can be placed above the recent swing high or the VWAP. A suitable exit point is when the price moves toward the previous day’s low or a key support level.

Example: Suppose Bank Nifty opened below VWAP in the morning session, but after the first hour, the price broke the VWAP and moved above. If volume is also supporting, it could be a bullish entry signal. On the other hand, if Bank Nifty opens above VWAP but falls below VWAP by mid-session and sustains below VWAP, it could be a bearish signal and provide an opportunity for short-selling.

VWAP is not always accurate: VWAP is a trend-following indicator, but it does not give accurate signals in every situation. In highly volatile markets, prices frequently cross VWAP, which increases the chance of false signals and whipsaws. Therefore, VWAP should always be used along with RSI, MACD, and price action to get better confirmation and avoid false trades.

4) Pivot Points

Pivot Points is a price action-based indicator that helps identify important support and resistance levels in the market. This indicator is very useful for intraday and swing traders as it tells at what level the price can reverse or break out. Pivot Points are calculated on a daily, weekly, or monthly time frame, which is a strong reference point for market participants.

Structure of Pivot Points:

• Pivot Level (P): The average price of the market, which indicates the trend.

• Resistance Levels (R1, R2, R3): Where the price can stop or come down.

• Support Levels (S1, S2, S3): Where the price can bounce and go up.

Entry, Exit, and Stop-Loss: Entry, Exit, and Stop-Loss using Pivot Points (with Options Strategy):

If the price is trading above the Pivot Point (P), the market is considered bullish, and traders can consider buying a Call Option. The ideal entry is when the price retests the Pivot Point and bounces upward, indicating that the level is acting as support. The first target for the move is R1, and if the price breaks this level with strong momentum, it can potentially move up to R2 and R3. A stop-loss for this trade can be placed below the Pivot Point or near the recent swing low to manage risk.

On the other hand, if the price is trading below the Pivot Point, it signals a bearish market, and traders can consider buying a Put Option. The best entry is when the price retests the Pivot Point from below and gets rejected, confirming resistance. The downside targets are S1, and if the selling pressure continues, the move can extend to S2 and S3. The stop-loss in this case should be placed above the Pivot Point or the recent swing high.

Pivot Points are not always accurate: Pivot Points are a reliable support-resistance indicator, but they do not always give accurate signals. Sometimes the price can consolidate around the pivot point or give a false breakout. Therefore, it is better to use pivot points along with indicators like RSI, MACD, or VWAP to avoid false signals and get better accuracy.

Example – Tata Steel (NSE: TATASTEEL)

SBI’s stock Price is Rs 750, R1 Rs 760, and S1 Rs 745. If the price falls to Rs 745 and bounces from there, then it can be a buying opportunity. If the price goes to Rs 760 and falls from there, then it can be a selling opportunity.

5) Bollinger Bands

Bollinger Bands is one of the best indicators for option trading to understand volatility. It helps identify overbought and oversold conditions in the market. It consists of three bands that track price movements and expand or contract based on market volatility.

• Upper Band: When the price touches or crosses this band, it may indicate that the stock is overbought, suggesting a potential reversal or correction.

• Middle Band: This is typically the 20-day Simple Moving Average (SMA) and represents the average trend of the price. Trading above this band signals bullish momentum, while trading below it signals bearish momentum.

• Lower Band: When the price touches or moves near this band, it may indicate that the stock is oversold, suggesting a potential buying opportunity, though confirmation is necessary.

A specialty of Bollinger Bands is that they adjust based on market volatility. When the market is more volatile, the bands widen, and when volatility is low, the bands shrink.

Entry, Exit, and Stop-Loss: If the price comes near the lower Bollinger Band and forms a reversal pattern, it can be taken as a bullish signal. In such cases, traders can consider buying a Call Option. The entry is confirmed when the price breaks above the middle band (20-day SMA), indicating a momentum reversal. A good stop-loss level would be just below the recent swing low or the lower band.

Similarly, if the price approaches the upper Bollinger Band and gets rejected, it can be considered a bearish signal. Traders can then consider buying a Put Option. The entry is confirmed when the price breaks below the middle band (20-day SMA). In this scenario, the stop-loss can be placed just above the recent swing high or the upper band.

Bollinger Bands are not always accurate: Like every technical indicator, Bollinger Bands do not always give the right signals. If the market moves sideways, the price will repeatedly move between the upper and lower bands, which can lead to false signals and whipsaws. Therefore, Bollinger Bands should be used along with RSI and Volume indicators to get better confirmation and minimize risk.

Overview of Advanced Level Option Trading Indicators

While the technical indicators discussed earlier help identify the direction of the trend in the underlying security, it's important to understand that option prices are influenced by more than just price movement. Factors such as the Greeks, Delta, Gamma, Theta, Vega, and Rho, as well as Implied Volatility (IV), play a crucial role in determining an option's premium.

In this section, we’ll explore the top indicators for option trading at an advanced level, focusing on tools that go beyond simple price trends. So, let’s dive in:

1) Greeks (Delta, Theta, Gamma, Vega)

Option Greeks are key metrics that influence how option premiums move in response to changes in market conditions. Mastering these is essential for making informed decisions, as without them, option trading becomes pure speculation.

Delta: It measures how much the option premium will change for every Rs 1 move in the underlying stock.

For example, if Delta is 0.60 and the stock rises by Rs 10, the option premium is expected to increase by Rs 6. A higher Delta means the option behaves more like the underlying stock, and it's also used to estimate the probability of the option expiring in-the-money.

Theta: It represents time decay, or how much value the option loses each day as it approaches expiry.

The closer you get to expiry, especially in the final week, the Theta decay accelerates significantly. This impacts buyers more than sellers, making time a critical factor in options trading.

Gamma: It measures the rate of change of Delta as the stock price moves. High Gamma means Delta can shift quickly, especially when the price is near the strike, which makes managing positions more volatile and reactive.

Vega: It indicates how much the option price will change with a 1% change in implied volatility (IV). Options with longer expiries and those at-the-money usually have higher Vega, meaning they gain more value when market volatility increases.

2) Implied Volatility (IV)

Implied Volatility (IV) is a key component in option pricing that reflects the market's expectation of future volatility. It does not predict the direction of the move but indicates how large the price movement could be. A higher IV generally leads to higher option premiums, while a lower IV results in cheaper premiums.

How to Use IV?

• If IV is high, it means that there is more uncertainty in the market, and the price of the option is expensive. This is best used for option selling, as sellers can collect higher premiums and benefit from volatility contraction.

• If IV is low, it means that the market is stable and options are cheap. This is best used for option buying, as buyers can enter positions at lower costs with the potential for expansion in volatility.

Common Mistakes to Avoid When Using Option Trading Indicators

Now that we’ve identified the best indicator for option trading, it’s important to remember that even the most effective tools can lead to losses if misused. Here are some common mistakes to watch out for when using these indicators:

Relying Only on Indicators

Indicators are helpful, but it is equally important to understand the market context. Trading blindly on just the RSI or MACD signal can be a wrong decision. The market is also affected by news, earnings reports, global trends, and economic events, which are not reflected by indicators alone.

Using Too Many Indicators

Many traders think that the more indicators they use, the more their accuracy will improve. But too many indicators only increase confusion and give contradictory signals. If one indicator is giving a buy signal and the other a sell signal, the trader becomes indecisive and may take the wrong trade.

Ignoring Risk Management

Indicators indicate the direction of the trade but are not a substitute for risk management. Many traders do not place stop-losses or take over-leverage, due to which even a small mistake can lead to a big loss. Capital protection is the most important aspect of trading, and without risk management, any strategy can fail.

Conclusion

Indicators make trading easy and effective, but relying solely on indicators can be a mistake. Beginners can start with Moving Averages, RSI, and Bollinger Bands, while advanced traders can make more accurate decisions using IV, Open Interest, and Greeks.

But no indicator is 100% reliable, so it is important to use indicators in conjunction with market context and price action. Backtesting determines which indicator works in which situation. Practice and experience in the real market are essential for success.

Most importantly, learning never ends in trading. The market changes every day, and it is important to find new strategies. If you use indicators correctly, follow risk management, and maintain discipline, both your trading and profits will improve

FAQs

Q1. What are the best indicators for options trading?

The top indicators for options trading are Moving Averages, MACD, VWAP, Pivot Points, and Bollinger Bands.

Q2. Can an accurate trade be taken with just one indicator?

No, a single indicator is never 100% reliable. For best results, use a combination of 2-3 indicators, like VWAP + RSI + Supertrend for intraday trading.

Q3. Why is IV (Implied Volatility) important in option trading?

IV tells how volatile the market can be in the future. High IV means that the option premiums will be expensive, and low IV means that the premiums will be cheap.

Q4. How does the VWAP option trading indicator work?

VWAP is useful for intraday traders, who calculate the average price based on volume. If the price is above the VWAP, then there is a bullish trend, and if it is below, then there is a bearish trend.

Q5. What is the best setting for RSI?

The default setting is a 14-period, but short-term traders can use a 7-period RSI for better signals. RSI below 30 is considered oversold (buy signal), and above 70 is considered overbought (sell signal).