Sometimes the stock market seems like a manic depressive beast. First it rises up snorting fire, then it curls up and retreats without much rhyme or reason.
There’s an old Wall Street adage that says “the crowd is right on the trends, but wrong at both ends.” Investors, and traders for that matter, are often caught off guard during major turning points. The stock market has an uncanny way of throwing nasty curves just when we’re expecting a nice, fat fastball grooved right into our wheelhouse.
The contrarian-minded are therefore cautious when they see signs the crowd is leaning too bullish or bearish. This is where a favorite tool among many old-timers comes in: the put-call ratio. A put-call (P/C) indicator can be applied to most any share of stock, index, or other instrument that’s linked to options markets. But for our discussion, we’ll focus on the ratio for all U.S.-traded options.
Options markets are massively complex. But for this discussion, let’s use greatly simplified terms: bulls and bears duking it out inside the ring, battling for control of market direction. A P/C ratio around 1.0 indicates roughly an equal number of put options and call options traded on a given day. In terms of market sentiment, it looks like a split decision.
However, because put options are often used to hedge stock portfolios (particularly index-based puts), the put-call ratio tends to spike during times of extreme pessimism and bearishness. Demand for puts increases as more people seek out protection during tumultuous times, driving the ratio to 1.1 or higher. This happened a few times last year (see figure 1). Conversely, when stock prices are stable or rising, you’ll often see a P/C ratio of 0.7 to 0.9 (at the close of trading January 16, the ratio was 0.91).
The P/C ratio is based on trading volume, after all, so it’s worth keeping an eye on the overall level of buying and selling. Falling stock prices and heightened volatility tend to spur higher trading activity in the options market. While past performance guarantees nothing about the future, looking back at volume trends can offer historical perspective.
For example, amid a broad marker slump, U.S. options volume during October soared to a daily average of 21.4 million contracts, up 30% from an average of 16.5 million for the previous three months, according to the Options Clearing Corp. In November, after things calmed down, daily options trading averaged 15.5 million contracts before jumping to more than 18 million during the first half of December.
On the Contrary
Volatility spikes happen, as history shows. But traders often look at these episodes as opportunities to swim against the tide. Indeed, the October action was eye-opening, not just because of the magnitude of the market’s decline, but also for the speed of the recovery. Over the span of a few weeks last fall, the Standard & Poor’s 500 Index tumbled over 10%. But guess what? The market found its footing and bounced back.
Watching options volume and the P/C ratio, as well as volatility gauges such as the CBOE Volatility Index (VIX), can help isolate these periods of extreme negativity and allow you to take a step back. Yes, it can be daunting to go against the crowd when the headlines are grim. But watching indicators such as the P/C ratio may help identify opportunities to latch on to an eventual rebound before it happens.