Options Put/Call Ratio Tips Bearish

One options pro sees bad news coming from an old favorite of indicators.
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In trying to squeeze blood from the options stone this holiday Friday, there is one options trader who's jumping up and down about a clear "sell" signal on a tried-and-true indicator: the equity put-call ratio.

The equity-only put-call ratio is computed daily by dividing the put volume of all stock options by the call volume of all stock options. Think

Alice in Wonderland

: As a looking glass, the ratio reflects something but often the opposite of what you'd expect.

The equity put-call ratio "is a contrary sentiment indicator, and when 'too many' people are buying calls it indicates a sell signal for the broad market," says options dean Larry McMillan of

McMillan Analysis

in Morristown, N.J. Many options traders believe that increased activity in either direction reflects the end of a particular cycle.

"We keep track of this and other put-call ratios by using a 21-day moving average. A sell signal is defined this way: When the 21-day moving average begins to rise, leaving a bottom that exists for at least 10 trading days, a sell signal is generated."

That moving average has fallen below .40, showing that for every 4 puts traded, 10 calls have crossed the transom. And even though some of that could be call selling, it's still seen as an unhealthy tilt.

The ratio's average bottomed on Tuesday, May 18 and by Tuesday, May 25, had "called" a sell signal. "The numbers that were dropping off the moving average were such that it was nearly impossible for the 21-day moving average to fall back below that low of May 18 in five days. Thus a sell signal was formed," he explains.

Not only that, he adds, but sell signals that occur in May or later seem to be more successful than those in January through March.

On Friday, the widely watched Chicago Board Options Exchange's equity put-call ratio was 0.39 at midday, on volume of 175,702 calls and 67,756 puts traded.

Even in the face of today's light volume, there weren't the odd end-of-week rumors circulating on the trading floor: Conflicting signals on

Merrill Lynch

(MER)

and a potential takeover by

Chase Manhattan

(CMB)

remain so.

As McMillan points out, "stock volume patterns remain negative on Merrill," which saps some of the legitimacy out of the takeover rumor.

But even though the

Chase

(CMB)

-Merrill rumor is harder to kill than

Friday the 13th

's Jason, "that doesn't mean it's not going to happen. The rumors haven't died, and that was eight dollars ago," says one Philadelphia-based options trader. According to this source, speculation is pointing to a "$115-per-share deal."

Recent options trading volume is higher, at 27,315, than the historical average 6,754, he added. Among the most actively traded series were the July 110 calls in Merrill, down 1/8 ($12.50) to 2 ($200) on volume of 3,714 contracts, easily passing the open interest of 1,778.