3 Technical Indicators to Check Before the Trade

Options contracts have limited lifespans, so it can be a challenge to figure out which options will move within the duration of the contract. Setting the right indicators could potentially help traders identify directional bias. 

Some option traders focus on volatility and trend. Here are three technical indicators a trader can add to their charts when managing strategy.

No one indicator has all the answers, but adding some carefully chosen indicators together on a chart can potentially help a trader determine if a stock is trending, which direction it's trending, and how much momentum it has.

To add indicators to your charts, select the Charts tab on the thinkorswim^® platform, pull up a chart, select Studies, then Add Study, and finally All Studies. There's a long list of indicators, so it's important to carefully consider which to use. Keeping volatility and directional bias in mind, let's review three categories of indicators.

Trend-following indicators attempt to identify market trends and use a system to profit from those trends. We're going to explore two: moving averages and the MACD.

A moving average plots a line on a chart that weaves through prices to show general price movement, including simple, exponential, and weighted moving averages.

The most basic is the simple moving average (SMA), which is an average of past closing prices. The 50-day SMA, for example, averages the past 50 days. Likewise, a 20-week SMA is the average price of the last 20 weeks.

The SMA's main objective is two-fold: to identify if price is in a possible trend and which direction it's moving. A quick glance at a chart can help answer those questions. The chart below shows a clear upward trend as expressed by the SMA. However, a trend can reverse at any time without notice.

The MACD is displayed as lines or histograms on a subchart below the price chart. The MACD and signal line on the chart below are oscillating around the zero line. The MACD line, by default, is the difference between the 12- and 26-period exponential moving average (EMA) of the close. The signal line, by default, is the 9-period EMA of the MACD. It's possible to change these parameters to reflect a preferred strategy.

It's possible to use the MACD for some of its trend following characteristics, but what traders are most likely to notice is that it's also a momentum study. The MACD focuses heavily on the difference in prices, or divergence. This information can potentially provide traders with information about momentum, as well as signaling potential trends because the MACD shows the differences between fast- and slow-moving averages.

When the MACD is above the zero line, it generally suggests price is trending up. When it's below the zero line, it often suggests a downtrend. Crossovers can also be used to indicate uptrends and downtrends. When the MACD crosses above its signal line, prices are likely in an uptrend. The opposite is often true for downtrends.

Divergence signals are also available with MACD indicators. A divergence occurs when the price moves in one direction, but the MACD moves in the opposite direction. A divergence could signal a potential trend change. It's difficult to determine whether the trend change will be a correction or a reversal, but a trader can get a possible idea by using the SMA and MACD together.

The chart below shows how price reacted to the SMA after a MACD divergence. Price broke through the SMA, after which a bearish trend started. It's not common to see a divergence early in an uptrend. Instead, price, SMA, and MACD will probably move up. This might indicate a bullish directional bias.

Once a trend starts, watch it, because it may continue or change. Where are prices in the trend? How much steam does the trend have left? This is where momentum indicators come in.

To measure price momentum, a trader can examine where a stock's price closed relative to previous closes or price ranges. Two common momentum indicators are stochastic and the Relative Strength Index (RSI).

The stochastic is an oscillator that moves from zero to 100 and goes up and down with price. It's derived from the closing price relative to the price range. If price rises and pushes the stochastic above 80, which is sometimes considered the "overbought" level, it suggests the trend may be losing steam, and prices could fall. In the same way, when price falls and the stochastic falls below 20, which is often considered the "oversold" level, it suggests selling may have dried up and price may rise.

RSI measures the averaged sum of one-period positive changes in comparison to negative changes in that same period. It considers all the one-period changes during a lookback period, rather than simply looking at the changes between first and last, like a trader might see with a standard momentum study. For example, a 10-day period RSI will look at the prevailing closing price relative to the closing price of the prior 10 days.

In the chart below, when the stochastic and RSI hit oversold levels, the price moved back up. However, both these momentum indicators can remain in overbought/oversold areas for extended time periods.

There's no single indicator that can tell a trader when a trend will reverse. But some have a combination of trend, momentum, and trend-reversal characteristics. To determine when a trend might be reversing direction, some traders use Bollinger Bands^®.

Bollinger Bands are a potential indication of a stock's volatility. Bollinger Bands drape around prices like a channel, with an upper band and a lower band. Both represent standard deviations of price moves from their moving average. Using Bollinger Bands, depending on the underlying and how prices are distributed, can help traders understand how volatile an asset might be by demonstrating how far the price is moving from its average.

When price hits the lower band, a trader might assume the price could potentially move back up, and when the price hits the higher band, the assumption might be that the price could fall. However, the stock's price might move outside the bands.

In some cases, the bands might contract or "squeeze." When that happens, a trader might consider it a warning of a potential impending reversal. When price breaks out of the upper bands, it might indicate an uptrend, and prices may trade along the upper band. The opposite potentially happens in a downtrend.

Bollinger Bands may also signal the slowing of a trend's momentum. When a bullish trend slows down, the upper band starts to round out. But it's what price does after the rounding out that could confirm if the momentum is slowing. If price approaches the mid-band, then moves toward the lower band, then moves along it, the trend has likely reversed.

When using these three types of indicators together, a trader might choose one from each category (trend, momentum, and trend reversal). For example, a trader might select MACD for trend, RSI for momentum, and Bollinger Bands for trend reversal.

To add these indicators to a chart, navigate to the Charts tab and enter a symbol, then add RSI, MACDTwoLines, and Bollinger Bands studies to the chart.

Here are three examples of how to potentially read the indicators on the above chart:

1. At the beginning of the uptrend, the Bollinger Bands squeeze, and there appears to be a bullish crossover in the MACD. The RSI indicator appears to be rapidly moving into overbought territory. Maybe it's time to think about directional trades with a bullish bias.

2. At this point on the chart, the Bollinger Bands start narrowing—an upward trend could potentially change. While prices are moving higher, the MACD and RSI are moving lower. Momentum appears to be slowing. Prices seem to be moving in a tight range within the Bollinger Bands. Divergence between the MACD and price suggests the uptrend could potentially reverse.

3. Now at the potential beginning of a downtrend, the Bollinger Bands round out as price breaks through the middle band toward the lower band. Notice how prices move back to the lower band. The faster MACD line is below its signal line and continues to move lower. The RSI also moves lower, reaching the point that some traders consider "oversold." All indicators appear to confirm a potential downtrend. Perhaps it's time to consider putting on directional trades with a bearish bias, such as long put verticals or short call verticals.

In some cases, it's easy to see how indicators work on a chart in hindsight. As you practice analyzing charts and using indicators, you might be able to glean information that can help you recognize and leverage directional bias and momentum.