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Use the Put-Call Ratio to Gauge Stock Market Sentiment

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July 15, 2012

To follow or bet against the crowd? Some say it depends on how you’re reading them.

One way to gauge short-term investor sentiment in the stock market is the put-to-call ratio; an indicator that measures the amount of put activity relative to call activity in the options market.

Investor sentiment tends to matter more when certain indicators are hitting extremes. Those readings typically don’t last long, but when they do happen, reversals in price can occur.

When everyone seems upbeat, optimistic, and bullish, they can’t all possibly be right. Right? Contrarians—those who typically buy or sell against prevailing trends, the bears in this case—would say when everyone’s already buying equities, who’s left to buy? At that point, it might make sense to adjust your own long portfolio strategy by hedging your positions, reducing equity exposure, or moving to the sidelines, as the probability increases that a market reversal is near. On the other hand, when pessimism, negativity, and bearishness dominate investor sentiment, perhaps it’s time to bottom fish or increase your equity exposure.

So, the question is: When to act?

Unfortunately, the art of contrarian thinking isn’t easy. Objective information is needed to gauge whether sentiment is bullish or bearish. The put-to-call ratio (p/c ratio)—an indicator that measures total put-option volume relative to call-option volume—is one such tool, and you don’t have to be an options trader to potentially benefit from it.

Getting P/C

Let’s review. A put contract gives the holder the right to sell a specified amount of the underlying security (like a single stock or an index) at a specified price and date. A call is the right to buy the underlying security. P/C ratios can be computed for any market or instrument that has listed options. The math is simple: puts divided by calls. For example, the Chicago Board Options Exchange (CBOE) computes a put-to-call ratio for all options trading on the exchange. Millions of contracts trade on the CBOE each day, and p/c ratios, volume, and other data are posted in the Daily Market Statistics section of the company’s website.

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FIGURE 1 Long-term trend on the P/C ratio. When it hits extremes, time to keep your eyes open. For illustrative purposes only. Source: Options Clearing Corp.

For example, take October 10, 2011 (FIGURE 1). The CBOE reported that 2.02 million puts and 1.67 million calls traded on the session, and the p/c ratio was 1.21 (or 2.02/1.67).Historically, a p/c ratio below .75 is a sign of high levels of bullish sentiment, and is considered bearish from a contrarian view Between .75 and 1.00 is neutral. Above 1.00 indicates high levels of bearishness, and is considered bullish by contrarians.

Again, on October 10, 7.76 million puts and 7.47 million calls traded across the exchanges, according to the OCC, and the ratio was 1.04. Like the CBOE ratio, below .75 is a sign of high levels of bullish sentiment, between .75 and 1.00 is neutral, and above 1.00 indicates high levels of bearishness or negativity.

The total p/c ratio spiked on August 8, 2011. The S&P500 fell to its lows of the year and had suffered a three-week 16.7% nosedive. The next day, the market fell again before staging a dramatic one-day rally, when the S&P500 surged 4.7% in a single day. Extreme bearishness set the table for the one-day rally, and the spike in the put-to-call ratio warned that negativity was extreme.

P/C ratios can be applied to stocks and sectors as well. If you want to gauge sentiment towards semiconductor stocks, for example, look at the p/c ratio on any of the large chipmaker stocks.

Do you think bearishness is too extreme in the bank and brokerage stocks? See how many puts and calls are trading on a financials exchangetraded fund. Want a potential read on broader-market sentiment? Check the P/C ratio on the S&P 500 index options. And so on.

Learning to Read

While p/c ratios may be useful, and can be applied to different markets, keep a few things in mind:

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FIGURE 2 Qualifying traders using the thinkorswim platform will find the P/C Ratio on an underlying stock under the “Trade” tab, then the “All Products” tab. For illustrative purposes only.

  1. FOCUS ON ACTIVELY TRADED MARKETS. If options on a stock trade only a few hundred contracts per day, the ratio can produce misleading signals. For example, an investor might sell 400 puts on the stock one day and make a bullish bet—yet the ratio spikes, indicating bearishness.

  2. CONSIDER THE MARKET ACTION. If a stock is rallying to new highs and the put-to-call ratio spikes, it’s probably not a sign of bearishness. Extreme bearishness typically surfaces after a period of falling prices.

  3. LOOK AT TRENDS OVER TIME. Some markets see more hedging activity (i.e., put buying) and will have higher p/c ratios. It’s important to establish a norm, or average reading, for each market.

  4. NO INDICATOR IS AN ISLAND. P/C ratios are not standalone tools or tickets to riches. It’s typically best used with other sentiment data, as well as fundamental analysis of the market or technical studies of chart trends.