Understanding the Put-Call Ratio the Right Way

In this podcast episode, we'll discuss the put-call ratio and investigate if it is a useful market indicator.
Understanding the Put-Call Ratio the Right Way
Kirk Du Plessis
Oct 18, 2019

When it comes to market signals and timing indicators, the Put-Call Ratio is one that naturally jumps to the top of many lists. Because the indicator looks at volume in both put and call options, the logical conclusion is that we can interpret the ratio as a signal of an impending top or possible market bottom. But, is that really the case? And, if so, how should we use Put-Call Ratios moving forward in our analysis? All this and more on this week's podcast episode.

How to Calculate the Put-Call Ratio

  • Take the total volume of put options that were traded and divide by the total volume of call options that were traded. This gives you the put-call ratio.
  • When the ratio of put to call volume becomes really high, it may indicate a reversal to the upside because traders are, perhaps, overly bearish.
  • When the put to call ratio is really low, it may indicate the market is ready for a reversal to the downside because traders are, perhaps, leaning too bullishly and not employing enough downside protection via puts.
  • CBOE intraday put-call statistics are available in 30 minute increments on the CBOE website. YCharts has the CBOE put-call ratio in the Market Indices and Statistics section of its website. On Stockcharts.com, the daily put-call ratio can be found using ticker “$CPC” 

Limitations of the Put-Call Ratio

  • The ratio only looks at volume.
  • Understanding liquid markets requires more than just volume. For example, incorporating changes in open interest can provide additional context to volume.
  • Volume is just one way to analyze market liquidity and activity.
  • There is not a lot of consistency in the predictive power of the put-to-call ratio. 
  • The consensus in the investment community is that the put-call ratio doesn't really have strong predictive power for forecasting market movements in either direction.

When are Put-Call Ratios useful?

  • Put-call ratios are incredibly useful when it comes to building a broad case for why a market might be overbought or oversold. 
  • It is an interesting data point, broadly speaking, to be considered in conjunction with other indicators.
  • The put-call ratio can alert you to what might be going on, but it is on a case-by-case basis.

Case Study

  • Today on the S&P, the put-call ratio is 0.971--which is almost a 1:1 volume for put options to call options.  
  • Over the last five years of the S&P, the average is around 1.6.
  • October and December of 2018 both had some of the highest put-call ratio readings--over 2. 
  • Both of these dates coincided roughly with when the market bottomed out. 
  • Again, this is interesting to note but not always the case. 
  • On July 26 of 2019, the put-call ratio was 0.93, which coincided with the market reaching its peak for the year.
  • Very interesting to note, and one extra data point to add to your analysis.

Conclusion

  • The put-call ratio is a good tool and an interesting data point to consider.
  • However, it is by no means anything you should build an entire trading strategy around. 
  • It's more of a macro, directional trend indicator to use and review from time to time. 

Option Trader Q&A w/ Ken

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Ken:

My question is about the value of rolling a trade into a future month. In your podcast, you are often saying we should take a non-emotional approach to trading, but I feel like rolling a trade to a future month is an emotional reaction trying to save a trade. Because, aren't we really just closing that trade at a loss and opening another trade for the next month for a slight credit in the same underlying? Wouldn't it be a better use of the risk capital to find a trade in another underlying that produces more potential profit?”

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

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