Put/Call ratios are funny animals. They tell us the degree of buying or selling pressure by monitoring the volume of puts and calls, then we flip the numbers around and interpret them opposite to what they are telling us. In this way Put/Call ratios are used as gauges of market sentiment, as they measure bullishness or bearishness by comparing the number of puts and calls traded. We interpret them upside down because when put volume becomes excessive in relation to call volume, it is an indication of excessive bearishness in the market, which can telegraph a market bottom and is usually bullish. But on the other side, when call volume becomes excessive in relation to put volume, it is an indication of excessive optimism and bullishness in the market, which is usually bearish. This is why the Put/Call ratio is called a contrarian indicator.
The Put/Call Ratio is simply the number of put options contracts traded in a given day divided by the number of call options contracts traded that same day. The put volume divided by the call volume yields the Put/Call Ratio.
In theory you will buy the market when the ratio gets too high and sell when the ratio gets too low. Thats the easy part the hard part is putting this into practice. First of all you have to define what is too high and what is too low. And then you have to think about how does the too high and too low change over time? And how does too high or too low change during a bull cyclical or bear cyclical or can this change from secular market to secular market.
Although you can create a put/call ratio on any equity or index that has listed options the two that technicians use the most is the Index option put/call ratio and the equity only put call ratio.
The Index PC ratio is computed using only OEX options for that is the index used the most for speculation. Therefore the Index PC ratio will give the most clues as to what the average trader is doing. Larry McMillan, author of many books on options and what many consider to be the guru of options, has looked at the PC ratio of all index options and has found it not to be a useful number.
The next major PC ratio is the equity PC ratio and as the name implies, is a ratio calculated by using the volume of all stock options.
A third Put Call ration that some technicians will use is the combination of the two, the index added to the equity-only ratio.
It is not worth while to calculate the PC ratio on most individual stocks because there is just not enough volume to give you a number that would mean anything. Of course the exception to this rule is PC ratios for stocks like Microsoft, IBM or Intel, stocks that have very large volumes, can be of value but generally a stocks PC ratio is not too helpful.
The debate as to which PC ratio to use, Equity or OEX, goes on but here are a few of the arguments to consider. Speculators use the index PC and, as stated earlier, can give hints as to whether the average Joe Trader is bullish or bearish. But some analysts think that the equity only ratio is the purer of the two because there is so little arbitrage in equity options anymore and the most money managers dont buy equity puts for protection they buy index (OEX) puts. So the equity only ratio could give a clearer picture as to the average Joe Traders true intentions. A good example of these was when in 1987 many technicians discarded the PC ratio as a useful indicator altogether. The index PC ratio gave a sell signal in July of 1987, which was a good thing considering what happened in October 1987. But in August the ratio began to climb and gave a buy signal in September so if you were only watching only the index PC ratio you were long going into the infamous October 1987 crash. On the other hand if you had been watching the equity only PC ratio you would have had a heads up because it gave a sell signal in July and never did get back to a buy before the crash. So what caused the index PC ratio to give the buy in August? We will never know for sure but most speculate that it was the institutions buying puts to hedge their holdings.
Interpreting the PC ratio as a contrarian indicator is tricky and should only be used if you truly think the options are purchased for speculation but once you introduce the fact that options are used for hedging then the use of this indicator gets even murkier. So here is the question you have to ask yourself. If you see the index PC ratio bearish, is it because speculators are too bullish or is it because institutions are buying puts. Most assuredly it is the latter. Now you have to ask is the put buying by the institutions because they are bullish and using the puts to hedge their long positions or are they truly bearish. So as you can see this indicator although very useful cannot be used on a whim.
What I would like to propose is use the two differently. The majority of put volume represents bets against individual stocks by the small individual investors - the so-called "dumb money" that is usually wrong. On the other hand, since many institutions and professional traders (the "smart money") use the OEX options for hedging, when the OEX Put/Call ratio diverges from the Equity only Put/Call ratio, it can be a sign that "smart money" is moving counter to the trend. This makes the OEX ratio a non-contrarian indicator and the equity only ratio a contrarian indicator.
Here is the Equity only Put/Call Ratio with 21 MA overlay. As a contrarian indicator you could be having some worries here if you are bullish.
The 21 MA is trending down and in early July it did reach an extreme but is now back to normal levels.
Here is the Index Put/Call Ratio with a 21 MA overlay. As a non- contrarian indicator you could be having some worries here as well if you are bullish.
Here you see the 21 MA trending upwards but the ratio is not to extremes yet. It almost got there in early July but I think any print over 3.0 should awaken the bears and put the bulls on the defensive.
These charts also support my theory that you should use the Equity only and index put/call ratio in opposite ways. In early July the Equity only P/C Ratio hit extreme lows and the Index P/C ratio hit extreme highs.
I believe the Put/Call ratios are good predictors of market turning points. But beware of which ratio you are looking at. If using Equity Only Put/Call ratio use it as a contrarian indicator but if you are using the Index Put/Call ratio use it as a non-contrarian indicator.
Remember plan your trade and trade your plan