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Using Put/Call Ratios to Find an Edge

Stocks in this article: CPCE

You cannot have success playing this market unless you are paying attention to sentiment. In this wacky, emotionally-driven world decisions are made with the heart and not the mind. There are ways for us to objectively analyze the data, and one of my favorites is the put/call ratio. Now, there are different ways to interpret the data. Some look for extreme readings, others look for reversals and then some look for a trend. I prefer the latter (trend) as it contains confirmation. It's not always a smooth ride but to me trends are easier to following and often are stacked with other indicators such as put call and mutual fund flows.

The put/call shows us the amount of volume being bought or sold. As information, the historic average of the put/call is .60, stated simply 6 puts bought for every 10 calls purchased. This correlates with the upward trending historic market (more bullish than bearish). When put/call rises it is assumed players are reaching for protection of portfolios, buying puts to insure against a down move. This is simply a hedge and is a smart and often cheap way to insure a portfolio.

But the put/call analyzes activity -- buys and sells. If you're selling puts, that's bullish. If you're selling calls, that's bearish. So how do we know the difference, or does it matter? I'm asked this all the time - how can you tell? Fact is, it really does not matter, because there are two sides to every trade -- a zero sum game. Someone is taking a bearish side, someone is bullish. I look for volume and movement as keys to interpreting the data. Say the put/call is low and indicates complacency (too much bullishness), but the volumes are not high. Therefore we 'could' conclude not much conviction, skepticism and doubt if the market is rallying. We saw this recently as the market skirted higher. The wall of worry or doubt still present. The market can proceed higher.

The graphics here show a chart of the put/call where we look for extremes past the bollingers (not seen), reversals and trend moves. The put/call daily is dynamic so I like to smooth it out, using a 10 MA to confirm trends. The second graphic is the intraday data. The useful part is on the left side, or the equity put/call. Index ratios are skewed toward institutional hedging and not relevant in terms of a sentiment indicator.

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