How Put/Call ratio reveals market’s future

The Put/Call ratio measures the sentiment of speculative option traders. A high Put/Call ratio indicates that option buyers favour puts, and are bearish. Historically, their pessimism has been ill rewarded, as the market has instead forged higher. A low Put/Call ratio signifies a relative dearth of put buying and a preponderance of bullish call buying. The record shows that option buyers’ optimism is usually shortlived, as the market declines instead.

A call is an option to buy common stock; a put is an option to sell common stock. A call buyer hopes prices will rise; a buyer of a put option wishes prices to fall. Both calls and puts receive their value from the price of the stock itself and option speculators’ judgments of the future course of the stock’s price movement.

Consider, for example, the valuation of a call option. If a stock sells at $25 and a speculator owns an option to purchase that stock for only $20, the value of the option is $5. Any price less than $5 would prompt a massive purchase of call options, an immediate payment of $20 and a resale of the acquired stock at $25, for a profit. Hence the theoretical value of the option is $5. Actually, because of a variety of other factors, the option price will usually be somewhat above $5.

One of these factors is the possibility of large percentage gains. If, in our example, the stock rises in price to $30, the option to buy it at $20 is worth $10. (Paying $10 for the option plus $20 for the stock by exercise of the option is akin to paying $30 for the stock in the first place.) Note that while the common stock has advanced 20%, from $25 to $30, the option value has doubled, from $5 to $10, a 100% gain and five times the percentage stock gain. This is obviously a highly leveraged and profitable situation.

Of course, there is a corresponding risk. If the stock declines from $25 to $20, the call option would be theoretically worthless. While a common stock investor would lose only 20% of his original investment, a call buyer would lose his entire investment. (Put options are diametrically opposite to call options. The space will not be devoted here to explaining their reward and risk opportunities. Suffice to say that the buyer of a put option only makes money when the stock declines in price, whereas the call option buyer makes money when the stock moves up.)

Option buyers are plainly a special breed. They shoot for large, highly leveraged profits. In return they risk catastrophic loss of capital. It often seems to be the case that the sentiment of extreme risk takers yields valuable clues to future market behavior. Option buyers are no exception.

If the volume of call options in a given period is greater than the volume of put options, one may logically assume that option speculators as a group are expecting higher prices and are bullish on the market. On the other hand, if the volume of put options is relatively greater than that of calls, these same speculators hold a generally bearish attitude.

Option traders lose money on balance. Their judgments of the direction of individual common stock prices, and of the market as a whole, are usually wrong. Therefore, a high Put/Call ratio (a large volume of puts relative to calls) usually precedes a period of rising prices, not falling prices as the option speculators would prefer. Conversely, a low Put/Call ratio (indicating relatively little put buying activity and greater call buying activity) is invariably followed by declining prices instead of rising prices as the preponderance of option buyers desire.

In the US from 1945 to 1976, the Put/Call ratio was computed using volume in the over-the-counter options market. In 1977, the options exchanges began trading both puts and calls on 25 stocks, and from 1977 to 1982 the P/C ratio was based on that volume. By 1983, the Ratio was expanded to use put and call volume on every stock with listed options.

To stabilise the indicator, we utilize contract volume only for those puts and calls with a striking (exercise) price within 10% of the current market price of the underlying stock. This eliminates far “in the money” options and far “out of the money” options from the tabulation.

First, a Put/Call ratio is computed for options in which the stock price is greater than the strike price but not more than 10% above it. A second P/C ratio is computed for options in which the stock price is below, but not more than 10% below, the exercise price. The two ratios are then simply averaged to derive the overall market logic P/C ratio.

Low readings (20% to 35%), signifying excessive call speculation, are bearish. High readings (above 140%), indicating excessive put speculation, are bullish. Bearish readings tend to be a bit early relative to market turns, but bullish readings frequently coincide to the very day with market, troughs. The market logic Put/Call ratio is one of the most sensitive and valuable of all market indicators now in use.

Option activity ratio: A derivative statistic of the put and call data is the so-called option activity ratio (OAR) calculated by dividing total put and call volume by NYSE volume. A high OAR is bearish for it signals the excessive option speculation that frequently accompanies market tops. A low OAR is bullish for the opposite reason: if there is a dearth of speculation, the market should be depressed and near a major trough. Recently the indicator has lost its usefulness. The sharp decline in over-the-counter option business during the last few years has thrown the OAR into a severe downtrend, rendering interpretation next to impossible. Several more years’ development of the registered option exchanges will be required to furnish sufficient data to construct the OAR anew.