The put/call ratio (p/c ratio) is probably one of the most recognizable option statistics. But how well is it understood?
The put/call ratio (p/c ratio) is probably one of the most recognizable option statistics among traders and investors, even by those who don’t regularly trade options. Yet, what this number is often thought to represent may not be accurate, and there’s some potentially insightful data that it misses altogether.
If you’re not familiar with this market data mainstay, the p/c ratio takes the total volume of put options and divides it by the total volume of call options traded in the same period, thus generating a ratio. It’s intended to provide a gauge of investor sentiment by measuring the volume of put options, which are considered to be bearish, versus the volume of bullish call options.
For instance, if option trading volume is equally split between puts and calls, the ratio would be 1.0. If put volume is twice that of call volume, then the ratio goes to 2.0. As the ratio moves higher, it reflects the very real fact that more put options are trading compared to call options. And that’s said to be a bearish indicator. But is it really?
One thing the p/c ratio can’t see is who is doing the buying and the selling of options, and why. Yes, if someone buys a put option, that’s typically considered to be a bearish bet, but it’s not always. The buyer might only want the options as a hedge on a stock investment. And remember, there are always two parties in every transaction: a buyer and a seller. Sometimes heavy put volume is the result of institutional traders selling put options. Not only does this happen when big traders think put options have become too pricey, but public companies have also been known to short put options in large numbers on their own stock.
Here’s an example: suppose shares of XYZ, Inc., are trading at $50. The board of directors has just approved a share buy-back program. With 30 days left until the XYZ 40 puts expire, the company sells 20,000 of them for $0.25. If the puts expire worthless, the company could add $500,000 to the bottom line. But what if the puts happen to be in the money come expiration? No big deal. XYZ buys the shares at $40 per the stock buy-back plan.
Of course, the p/c ratio goes ballistic when this trade, or any similar trade, is made, but it completely misses out on the who and why. We can’t just assume that every time a put option trades, it means that investor bearishness is rising.
On the other hand, sometimes puts are bought in large numbers precisely because investor bearishness is on the rise. And sometimes the p/c ratio completely misses it. Here’s how.
Suppose a manager of an equity fund turns bearish, but the fund doesn’t necessarily start selling its portfolio of stocks. Rather, the fund might buy out-of-the-money puts for protection, and it might also sell out-of-the-money calls to help pay for the protective puts.
The fund ends up with long stock, long puts, and short calls. Sound familiar? It’s a collar. When the long puts and short calls are traded in equal numbers, the p/c ratio completely misses it. However, there is one way to gauge how bearish this long put/short call trade becomes: watch the skew between the options. Although out-of-the-money (OTM) puts are normally more expensive than OTM calls, this difference gets bigger as put-buying increases.
This certainly doesn’t mean you want to completely throw out the p/c ratio. Just take it for what it’s worth, and consider using it in combination with other market indicators.