OAP 166: Understanding The Put Call Ratio The Right Way

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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 to signal us from 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.

Key Points from Today's Show:

How to Calculate the Put-Call Ratio

  • Take the total volume of put options that were traded, divided by the total volume of the call options that were traded. 
  • This gives you the daily or weekly put-call ratio.
  • When the ratio of put to call volume becomes really high, it may indicate a reversal to the upside.
  • When the put to call ratio is really low, the market is then potentially ready for a reversal to the downside. 

Limitations of the Put-Call Ratio

  • The ratio only looks at volume.
  • Understanding liquid markets require more than just volume.
  • Volume is just one way to analyze market liquidity and activity. 
  • There is not a lot of congruency between the predictive power of the put-to-call ratio. 
  • The consensus in the investment community is that put-to-call ratios don't really have any meaningful correlation with market predictions in either direction.

When Put-Call Ratios are 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.
  • The put-call ratio can alert you to what might potentially be going on, but it is on a case-by-case basis.

Case Study

  • On the S&P, the put-call ratio is 0.971. 
  • 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 that were over 2. 
  • In this time, it happened to be 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 value to add to your analysis.

Conclusion

  • The put-call ratio is a good tool and an interesting data point to look at.
  • However, it is by no means anything you should build a full-fledged trading strategy off of. 
  • It's more of a macro, directional trend indicator to use and glance at 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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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.