Podcast 3: Feb. 1, 2010
Put-Call Ratio
The put-call ratio is one of the most widely followed technical indicators for option traders. Although there are several variations, the basic indicator is simply found by taking the total volume of all put options traded for a particular day and then dividing that number by the total volume of all of the call options traded for that same day. And just to be clear, when I say “all calls and puts” I mean all strikes and expirations combined.For example, if you wanted to calculate yesterday’s put-call ratio, you would find the total number of puts and calls traded on that day regardless of strikes or expiration dates. If 1,000 put options were traded and 2,000 call options were traded, the put-call ratio would be 1,000 puts / 2,000 calls = 0.50. A put-call ratio of one-half means that half as many puts were traded as compared to calls.
Why would anyone want to track such a number? The idea is that the put-call ratio is a measure of investor sentiment. Do investors collectively feel the market will continue in its current direction – or are we due for a trend reversal? Many traders look to the put-call ratio for the answer.
Because of the way the ratio is constructed with the volume for puts in the numerator and the volume for calls in the denominator, the put-call ratio increases as the number of puts rise relative to the calls. Therefore, as the put-call ratio rises, it means more and more investors are becoming bearish.
Put-Call Ratio is a Contrarian Indicator
However – and this is important – traders do not interpret that as bearish signal as you might suspect. Instead, the put-call ratio is a contrarian indicator, which means the outlook is opposite of what the data may seem to foreshadow. If the put-call ratio is relatively high, it means there is excessive bearishness and would actually be interpreted as a sign that the market is about to turn to bullish.
Conversely, if the put-call ratio is relatively low then it is presumed to mean the market is overly bullish and a sharp downturn may be near. I’ll explain what is relatively high and low in a moment but first let’s answer an important question: Why do traders assume the opposite is going to happen? In other words, when put buying is relatively high, why do traders assume that means we’re about to enter a bullish trend? And when call volume is relatively high, why should traders feel the market is about to turn bearish?
Some people believe it’s because the trading crowd always gets it wrong – especially among speculators in the options market. However, that explanation by itself is highly suspect and should not be relied upon as a plausible reason. It’s not possible for the crowd to always get it wrong or to even get it wrong most of the time. For similar reasons that I discussed in the previous podcast on efficient markets, traders would eventually learn to adjust if there was always a large bias to the wrong side.
A better explanation centers on the supply and demand of the traders for calls and puts. For example, when the put-call ratio is relatively high, it’s because there are far more put buyers than call buyers. If the ratio is relatively high then nearly all of the put buyers have been exhausted and we have reached a point where there just aren’t many traders left who are willing to buy puts.
When traders buy puts, market makers hedge those puts by shorting stock and buying calls. The high put buying equates to a lot of short stock positions in the market. If no put buyers are left then any sign of a bullish bounce triggers many traders to cover their short positions, which whipsaws the market in the other direction to the bullish side. In other words, when the bears disappear, bulls are more likely to show.
The opposite is true if the market is extremely bullish as shown by relatively low put-call ratios. When speculation is rampant and everyone is buying calls, the put-call ratio gets relatively low and there probably aren’t many traders left who are willing to buy calls.
To create the long calls, market makers will hedge with long stock and long put positions. So when the put-call ratio is relative low there are many long stock positions in the market with very few buyers to push it higher. When there is a slight hint of a market downturn, the large supply of long positions is dumped on the market thus causing a rapid reversal from bullish to bearish.
That’s what causes the sharp reversals and it therefore pays to understand and track the put-call ratios.
What is High and Low?
So what are high and low put-call ratios? That’s a great question and the answer is that it depends on the time frame. The ratios change over time and are therefore relative. It’s kind of like asking what’s a high and low price for shares of IBM. Your answer would be very different depending on whether you’re talking about 1995, 2005, or 2010. Because of that, the best way to use the put-call ratio is to plot the historical ratios and see where they fall, which I’ll explain how to do in just a moment.First, understand that a ratio of 1.0 would indicate that there are equal numbers of put and call buyers which would lead one to believe that the market is neutral or indecisive about direction. However, historically, there are usually many more call buyers than put buyers – usually due to the upward bias of the market. Because of this, the put-call ratio normally rests below 1.0 so a put-call ratio equal to 1.0 would still be viewed as rather bearish even though equal numbers of puts and calls were traded. Put call ratios for equities near 0.5 or 0.6 are considered by most traders to be more neutral.
Where Can I Find Put-Call Ratio?
You can access daily data at cboe.com, which is the website for the Chicago Board Options Exchange. Just hover your mouse on the “Quotes and Data” tab at the top of their website and select “Daily Market Statistics” from the pop-up menu.
You can also download historical data by clicking “CBOE Volume & Put/Call Ratios” from that same menu. You’ll be directed to a webpage that allows you to download Excel spreadsheets with the data going back to 2003.
You will also see the CBOE has put-call ratio data broken down into three categories of equity, index, and total exchange. The equity put-call ratios just calculate it for stocks while the index put-call ratio uses various indexes. The total exchange data reflects the combined data.
At the bottom of the list, you’ll find an archive link that allows you to find the put-call ratios for the “total exchange” going back to 1995. Why does the CBOE separate the data between equity and indexes?
The reason is that the index ratios can be quite different since they are heavily laden with institutional put buyers seeking to hedge portfolios – not speculate on direction. The index put-call ratios are therefore viewed as not conveying the same sentiment for speculation and fear. So just as different time periods generate different put-call ratios so do different categories. Therefore, if you are going to use put-call ratios, be sure to select the category that is most relevant to your needs.
For example, since 2003, the average put-call ratio for equities is 0.66, which is in line with what I said earlier that traders consider 0.5 or 0.6 as normal. However, the average for the indexes is 1.54, which represents much more put buying. The indexes tend to have more put buyers since institutional traders such as banks and pension funds tend to buy the puts for insurance rather than speculation.
Let’s take a look at the more current index numbers to see where they fall. On January 29, 2010, the put-call ratio for the indexes stood at 1.49. Again, this means there were about one-and-a-half puts purchased for every call. The average over the past year is 1.26 so Monday’s put-call ratio was just a little higher than average. The big question is whether it is high enough for concern. This is where the art side of the interpretation comes in. Obviously, there are many ways and opinions on how to determine that perhaps by looking at support and resistance points, moving averages, Bollinger bands, and many other techniques.
One basic technique is to look for plus and minus two standard deviation marks, which is essentially all the Bollinger Bands are doing. The two-standard deviation mark just shows the high and low range that should include all put-call ratios 95% of the time.
Without getting into the calculations, based on the past year’s data, we should expect that 95% of the time, the put-call ratio will fall between 0.72 and 2.36. Remember now, those numbers are relative and may not apply next year. But based on Monday’s put-call ratio of 1.49, it shows the market is not at an abnormally high or low level right now. It is, instead, well within the ranges we should expect to see 95% of the time. Based on the put-call ratio theory, the market is not showing signs of concern for a sharp fall right now. At the same time, we shouldn’t expect abrupt rises either.
Dollar-Weighted Put-Call Ratio
Another, perhaps more accurate measure, is to use a dollar-weighted put-call ratio. With this method, the trader multiplies each of the put and call volumes by their closing prices before dividing.
The advantage with dollar-weighting is that you are calculating how much value traders are placing on the options. For instance, you could have an case where an equal number of puts and calls traded; however, if the call options are twice as expensive as the puts then it only makes sense that traders are willing to put twice as much money into the calls and we should therefore take that to mean traders are more bullish than bearish – even though equal volumes were traded. We can account for that by multiplying the option volumes by the closing prices. Put and call prices can be quite different since many traders buy relatively cheap, out-of-the-money puts as insurance rather than for bearish speculation. The dollar-weighted put-call ratio takes these price differences into account.
Regardless of which put-call ratio you use, remember it is like any other technical indicator. It is a number based on a mathematical formula based on a set of assumptions and is not a perfect indicator by any means.
In fact, it should be noted that the put-call ratio is probably not as valid of an indicator as it was in the earlier days. The reason is that traders have become far more educated and use calls and puts for things other than speculating on direction. For example, just because someone buys a put option does not necessarily mean they are bearish. They may, for example, be using that put option as insurance; that is, as a way to hedge a long stock position and are therefore really bullish.
Of course, we could argue that if a trader is 100% bullish then there would be no reason to buy the put. In other words, why waste your money on insurance if you feel there’s no chance for a fall? Obviously, anytime a trader buys a put there must be some concern for downside risk so the put-call theory still sheds an interesting light into the minds of traders and investors.
What does the research have to say? Most research shows the put-call ratio is a more of a reactive indicator; that is it shows bearishness after the market has fallen and bullishness after it has risen. In other words, the actual market leads the put-call ratio.
Still, any information is better than none and option traders should use all they can to help determine the timing and potential severity of market turns. Option prices decay over time and the less time spent waiting for your stock to move up or down, the better for you.
The put-call ratio also shows another important reason for understanding options – even for those who do not intend to trade or hedge with them. Options can be used as a window into the minds of traders.
Options trading and investing can be very rewarding but you must understand all of the fundamentals in order to master the art and science of options trading. For those who would like to advance their knowledge, you may wish to consider the Alpha Trader Certificate Course and Strategy Lab.
Knowledge is a risk-free investment and understanding the put-call ratio can only make you better at the art and science of options trading.