Forecasting Market Direction With Put/Call Ratios

By John Summa AAA

While most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of their value as predictive tools. Yet one of the most reliable indicators of future market direction is a contrarian-sentiment measure known as the put/call options volume ratio. By tracking the daily and weekly volume of puts and calls in the U.S. stock market, we can gauge the feelings of traders. While a volume of too many put buyers usually signals that a market bottom is nearby, too many call buyers typically indicates a market top is in the making. The bear market of 2002, however, has changed the critical threshold values for this indicator. In this article, I will explain the basic put/call ratio method and include new threshold values for the equity-only daily put/call ratio. (Find out how to play the middle ground in Hedging With Puts And Calls.)

Betting Against the "Crowd"
It is widely known that options traders, especially option buyers, are not the most successful traders. On balance, option buyers lose about 90% of the time. Although there are certainly some traders who do well, would it not make sense to trade against the positions of option traders since most of them have such a bleak record? The contrarian sentiment put/call ratio demonstrates that it does pay to go against the options-trading crowd. After all, the options crowd is usually wrong.

I can remember late 1999 and early into the new millennium, when option buyers were in a frenzy, buying up truckloads of call options on tech stocks and other momentum plays. As the put/call ratio pushed below the traditional bearish level, it seemed like these frenzied option buyers were like sheep being led to the slaughter. And sure enough, with call-relative-to-put buying volume at extreme highs, the market rolled over and began its ugly descent.

As often happens when the market gets too bullish or too bearish, conditions become ripe for a reversal. Unfortunately, the crowd is too caught up in the feeding frenzy to notice. When most of the potential buyers are "in" the market, we typically have a situation where the potential for new buyers hits a limit; meanwhile, we have lots of potential sellers ready to step up and take profit or simply exit the market because their views have changed. The put/call ratio is one of the best measures we have when we are in these oversold (too bearish) or overbought (too bullish) zones.

CBOE Put/Call Ratio Data
Looking inside the market can give us clues about its future direction. Put/call ratios provide us with an excellent window into what investors are doing. When speculation in calls gets too excessive, the put/call ratio will be low. When investors are bearish and speculation in puts gets excessive, the put/call ratio will be high. Figure 1 presents daily options volume for May 17, 2002, from the Chicago Board Options Exchange (CBOE). The chart shows the data for the put and call volumes for equity, index and total options.

The equity put/call ratio on this particular day was 0.64, the index options put/call ratio was 1.19 and the total options put/call ratio was 0.72. As you will see below, we need to know past values of these ratios in order to determine our sentiment extremes. We will also smooth the data into moving averages for easy interpretation.

Chicago Board Options Exchange (CBOE) Options Volume

VOLUME P/C RATIOS
EQUITY OPTIONS
Puts 462,520
Calls 721,163 .64
INDEX OPTIONS
Puts 134,129
Calls 112,306 1.19
TOTAL OPTIONS
Puts 596,669
Calls 833,624 .72
Figure 1: Daily options volume for May 17, 2002
Source: CBOE Market Statistics 5/17/02

Total Weekly Put/Call Ratio Historical Series
There are different ways to construct a put/call ratio, but the traditional CBOE total weekly put/call ratio is a good starting point. By total, we mean the weekly total of the volumes of puts and calls of equity and index options. We simply take all the puts traded for the previous week and divide by the weekly total of calls traded. This is the weekly total put/call ratio. When the ratio of put-to-call volume gets too high (meaning more puts traded relative to calls) the market is ready for a reversal to the upside and has typically been in a bearish decline. And when the ratio gets too low (meaning more calls traded relative to puts), the market is ready for a reversal to the downside (as was the case in early 2000). Figure 2, where we can see the extremes over the past five years, shows this measure on a weekly basis, including its smoothed four-week exponential moving average.

052102_c.gif
Figure 2: Created using Metastock Professional. Data Source: Pinnacle IDX

Figure 2 reveals that the ratio's four-week exponential moving average (top plot) gave excellent warning signals when market reversals were nearby. While never exact and often a bit early, the levels should nevertheless be a signal of a change in the market's intermediate term trend. It is always good to get a price confirmation before concluding that a market bottom or top has been registered.

These threshold levels have remained relatively range-bound over the past 20 years, as can be seen from figure 2, but there is some noticeable drifting (trend) to the series, first downward during mid-1990s bull market and then upward beginning with the 2000 bear market.

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Figure 3: Created using Metastock Professional. Date Source: Pinnacle IDX

Despite the trend, the smoothed put/call ratio is still useful; however, it is always best to use the previous 52-week highs and lows of the series as critical thresholds. My experience has been that put/call ratios are best used in combination with other sentiment indicators and perhaps a price-based (i.e., momentum) indicator. More elaborate mathematical massaging of the data (i.e., de-trending by differencing the series) can also help.

Equity-Only Daily Put/Call Ratio
Since it includes index options, which are used by professional money managers to hedge portfolios of stocks, the total put/call ratio can distort the measurement of the temperature of our purely speculative crowd. Arguably, a better gauge is the CBOE's equity-only put/call ratio. Figure 4 contains the CBOE raw daily put/call ratio and its 10-day exponential moving average - both are plotted above the S&P 500 stock index. As the bear market has shifted the average ratio to a higher range, the horizontal red lines are the new sentiment extremes. The past range, indicated by the horizontal blue lines, had threshold values of 0.39 to 0.49. The new threshold values are 0.55 and 0.70. Currently, the levels have just retreated from excessive bearishness and are thus moderately bullish.


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Figure 4: Created using Metastock Professional. Source: CBOE Market Statistics

Conclusion
Index options historically have a skew toward more put buying. This is because of the index put option hedging done by portfolio managers - this is also why the total put/call ratio is not the ideal ratio (it is polluted by this hedging volume). Recall that the idea of contrarian sentiment analysis is to measure the pulse of the speculative option crowd, who are wrong more than they are right. We should therefore be looking at the equity-only ratio for a purer measure of the speculative trader. In addition, the critical threshold levels should be dynamic, chosen from the previous 52-week highs and lows of the series, adjusting for trends in the data.

As with any indicators, they work best when you get to know them and track them yourself. While I don't like to use them for mechanical trading signals, put/call ratios do outline zones of oversold and overbought market conditions quite reliably. They should thus be included in any market technician's analytical toolbox. (After years of debate, options have changed. Find out what you need to know in Understanding The 2010 Options Symbology.)

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