While most options traders are familiar with the leverage and flexibility options offer, not everyone 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 a market bottom is near, 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.
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 it pays to go against the options-trading crowd. After all, the options crowd is usually wrong.
In late 1999 and early into the new millennium, 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…