Option Investor
Trader's Corner

Being Contrary

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Options traders buy puts and calls, and market pundits pay close attention to how many of each they buy. Savvy traders do, too.

The CBOE and the ISEE are two of the exchanges that produce ratios comparing the numbers of puts and calls purchased, all for the benefit of those savvy traders. One exchange produces an indicator that breaches a low threshold level when markets are topping: the other, an indicator that breaches a high threshold level when markets are topping. Savvy traders need to know which is which.

The CBOE offers several versions of its closely watched put/call ratios. Equity, index and total exchange versions, including historical data, can be found at www.cboe.com/data/PutCallRatio.aspx/. The names of the several versions are self-explanatory, but each divides any day's put volume on equity, index or total exchange by its call volume. As the volume of puts traded increases in relationship to the volume of calls traded, the ratio rises.

Many savvy traders view the CBOE's several versions as contrarian indicators. If markets have been declining and the ratio being watched rises above a certain threshold level, those traders believe that sentiment has grown too bearish. They theorize that the ratio has given a potential reversal signal. Conversely, if the markets have been rising and the ratio drops below a certain threshold level, savvy traders believe that the low put/call ratio signals excessive bullishness and a potential downside reversal in the making.

These reversal signals tend to be early, many have noticed, so they serve more as a warning that a reversal might be imminent than as a buy or sell signal. Many market pundits warn to combine this sentiment indicator with price-based indicators for confirmation. I would add my caution to use a put/call signal as a warning to get your trading plan in order, but then let price action dictate when or whether you act on that signal.

So how does this whole contrarian thing work, anyway? To understand, think about the two groups of traders: retail traders such as you and me and portfolio managers. The two groups tend to employ options differently. Many retail traders buy calls or puts to participate in an anticipated move. They're buying those options in lieu of buying stocks or futures because of the leverage options provide. Portfolio managers may be buying options to hedge a position. It makes a difference.

Many savvy traders who watch the CBOE's put/call ratios believe that retail traders, excusing themselves from this charge of course, are clueless. They chase moves. The more a market drops, the more puts retail options traders are buying, until they're buying the most puts and driving the put/call ratio above threshold levels just when the selling is about done and markets are ready to reverse. They're buying the most calls and driving the put/call ratio below threshold levels when markets are topping out. This is a simplistic explanation, of course, but it explains the thinking behind the choice of a put/call ratio as a contrarian sentiment indicator.

That's not the only rationale that might be behind the contrarian nature of the put/call ratio. Some researchers, including Bob Pelletier in "The Importance of Put/Call Ratios," believe that it's the portfolio managers, hedging new long portfolio positions with puts or hedging new short portfolio positions with calls, who are responsible for pushing put/call ratios beyond threshold levels as a reversal nears. These portfolio managers are then driving the put/call ratio higher as they're adding new long positions when they believe markets are bottoming and driving it lower as they're entering new short positions as they believe markets are topping. They're given more credit than the retail trader by some market pundits and by some of the savvier traders.

A savvy trader will then pick and choose among the various versions of the put/call ratios, depending on which theory that savvy trader endorses. The savvy trader who believes that it's the delusions of the retail options trader that are most important to watch will likely want to exclude the actions of the portfolio managers. That savvy trader will want to look at the CBOE's equity-only put/call ratio, because the portfolio managers tend to employ index-related options rather than equity options. Portfolio managers are, after all, hedging a whole portfolio and not a specific stock.

The savvy trader who wants to focus on the actions of the portfolio managers will choose one of the other two versions. This savvy trader who might study the OEX or index only put/call ratios, also available on the CBOE's website.

If you read a number of articles or talk to a number of traders, you'll get different answers as to which of the versions on the CBOE website is best to watch, so decide on your focus and then get to know that particular index's permutations. How does it tend to act? What are its particular threshold levels beyond which it's signaling a potential reversal?

To some extent, the threshold levels depend not only on the particular version of the put/call ratio a trader studies, but also the historical values for those ratios, particularly over the last 12-month period, and the current market climate. That wasn't always true. Although the put/call ratios and their four-week averages tended to stay within certain thresholds for twenty years, John Summa notes when writing for Investopedia.com that they've developed a tendency to drift with price action. Summa suggests using that four-week moving average to smooth the ratio. For example, on the chart below, the four-week moving average is encased in a channel that shows its slight upward drift over the last couple of years.

Annotated Daily Chart of the CBOE's Total Put/Call Ratio:

A few points might be made from the chart. First, I haven't chosen a traditional historical band to mark as horizontal upper and lower thresholds, but rather have chosen levels that also roughly correspond to the four-week moving average's touches of or violation of its rising channel. You may or may not agree with this technique, but combining the two seems to work as well for me as other techniques, especially for an indicator that proves helpful but not exact in its timing.

You might want to explore the ideas of other market watchers, with some of them more experienced at watching this ratio. Summa suggests horizontal thresholds surrounding a smoothed four-week average, with the horizontal lines at 0.45 and 0.70. If using the equity-only daily put/call ratio, Summa suggests using thresholds of 0.55 and 0.70 for a smoothed four-week average. Another writer suggests using 1.00 as a single benchmark, with a put/call ratio above 1.00 showing that markets are likely to rise and a number less than 1.00 showing that they're likely to decline.

As should be obvious, any number of writers will have any number of theories about those thresholds, and Summa's notation of a tendency of the smoothing average to drift appears to be correct. Savvy traders will read all these suggestions and find the one that works for them after some experimentation.

As noted earlier and now evidenced by the chart, this indicator is sometimes early. That tendency did show up on the chart, although the tendency was somewhat ameliorated if signals from both the four-week moving average and the ratio itself are required. Note, however, that the extreme thrust lower this spring was still very early, even though it had been preceded by the average's touch of its own support level. This backs up the caution to use the various permutations of this ratio as a warning to prepare a trading plan, but not to assume it will be needed any time soon.

Although traders might disagree about the threshold levels or the version of the put/call ratio to use, they do tend to agree that the signal is a contrarian signal. The ISEE's version is a contrarian indicator, too, but with some major differences. To calculate its version, the ISEE divides the call purchases (not volume, like the CBOE) by the put purchases and multiples by 100. Because calls are divided by puts, rather than puts by calls as in the CBOE's versions, this results in a sentiment indicator that is high when markets might be topping and low when markets might be bottoming.

Look for current values, charts, and some moving averages for this indicator at www.iseoptions.com/. Answering a question in STOCKS & COMMODITIES, writer Tom Gentile suggests threshold levels of 200 and above for possible topping-out action and 125 or less for possible bottoming action.

The information on the ISEE site clarifies that transactions from firms and market makers are not included in this sentiment indicator. Those who adhere to the theory that it's the poor deluded retail trader whose creates the extremes in a sentiment indicator of this type might prefer to study the ISEE's version to see if it provides helpful alerts to extreme bullishness or bearishness. They might begin with a study of Gentile's benchmark levels, but charts on the site show that the indicator has been drifting downward all this year. It's spent quite a bit of time this year at the 100 mark, below that suggested 125 benchmark. Its value on September 28, for example, was 101. For the previous 60 days, the ISEE had placed automatic benchmarks at 159.33 and 105.67.

These charts might not return exact levels to watch, with those thresholds subject to interpretation and showing a tendency to drift over recent years, but they're still helpful to savvy traders. For those who believe in the value of contrarian indicators, they can provide a heads-up that it's time to be thinking about a new trading plan, to be put into effect when price action confirms the reversal. Savvy traders can pick one to study and get to know its peculiarities.

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