Traders like simple indicators using market-tested data, and preferably those that give a snapshot of the market’s underlying psychological mood at any point in time. An indicator like this provides a good basis on which to trade, either with or against the prevailing market climate.
The put-call ratio is a good example of this, not least because options are widely used by market professionals and because they are traded in standard-sized lots through a central market.
The indicator shows the volume of put option contracts traded in a particular market index divided by the number of call option contracts traded. It would generally be looked at on a daily basis, or possibly after a big market movement has taken place. The daily results can be translated into chart form to provide some perspective. Put and call option volume in market indices, or the data from which to calculate them, are published online and in some sections of the financial press.
So, what could be easier? But interpreting put-call ratios is nothing short of an art. One reason is that options are used both for speculation and hedging. So the volume data on index puts, for example, include those who are betting the market will fall, and those who think it might or might not drop, but want some insurance just in case.
So the obvious point that the higher the ratio, the more bearish sentiment is becoming, while correct, doesn’t necessarily tell the whole story. The other point is that the put-call ratio often differs widely for individual equity options and for index options.
According to recent CBOE data for the US market, for instance, the put-call ratio for S&P index options was 1.9 (roughly twice as many puts as calls traded), but for equity options the figure was 0.52 (roughly twice as many calls as puts traded). Latest data for FTSE100 index options on NYSE-Euronext show a similar picture. The index put-call ratio is 2.15, while equity option data show a put-call ratio of 0.57.
Most traders, however, probably confine their interest to the index option put-call ratio as being the best guide to overall market sentiment – which really the object of the exercise.
Another big reason for taking care when interpreting the put-call ratio is that at the margin it is frequently a contrary indicator. Extremes in put-call activity, for instance a sharp upward or downward spike in the index, indicate on the one hand a climate of fear in the stock market or, on the other hand, excessive optimism. In both cases it may be right to trade against them.
When does normal bearishness or bullishness turn into panic selling or buying, and change from a being a straightforward guide to sentiment into a sign that astute traders should do the opposite to the crowd? There is no real way of knowing other than experience and instinct, although other indicators of market sentiment may also confirm a climate of out-and-out greed or blind fear.
Long term charts of the put-call ratio show regular, and quite sharp, swings when the data is plotted over several years. A better guide for traders is perhaps the trend over several months. Some traders also plot the chart of the index of implied option volatility (the VIX) on the same chart as the put-call ratio. The data is, of course, related and in a way complementary. The VIX measures volatility as implied by option prices, the put-call ratio trading volume. But trends in one index often confirm movements in the other. Both need interpreting with care.