I recently mentioned that I had begun a large research project to investigate historical patterns connecting options data to future movements in stocks. Some of my initial efforts have focused on the equity put/call ratio and its relationship to future equity index movements.
Suppose, however, we treat the put option data and the call option data as completely different time series. Might there be information in each that is obscured when we solely focus on the put/call ratio?
As a result, I calculated the ratio of each day's equity put volume relative to the average equity put volume over the past 100 trading sessions. This we will call the put ratio. I then calculated the equity call volume relative to the average equity call volume over the past 100 sessions. This we'll refer to as the call ratio.
Armed with a separate put ratio and call ratio, we can address the question of whether relative peaks and valleys in equity call and put volume reflect sentiment shifts that impact future stock prices.
Additionally, we can form a new relative put/call ratio that is the put ratio divided by the call ratio. In other words, the relative put/call ratio identifies whether we're getting more put or call activity in the market as a function of the past 100 days' volume.
It turns out that elevations in puts and calls have different impacts upon the S&P 500 Index (SPY). And the relative put/call ratio does a pretty good job as a sentiment measure and as a predictor of S&P 500 prices 1-20 days out. Tomorrow I will begin detailing some of these findings.
For now, suffice it to say that the relative put/call ratio got very low in mid November prior to the short, steep market drop. We have since moved to neutral levels in the put ratio, call ratio, and the relative put/call ratio.
When we have had such neutral levels on a one-day basis (N = 126), there has been no overall edge--bullish or bearish--over the next 1-2 days. When the neutral day occurs during a bearish five-day relative put/call period, however, the next two days in SPY average a gain of .24% (40 up, 23 down). When the neutral day occurs during a bullish five-day relative put/call period--which is what we have at present--the next two days in SPY average a loss of -.11% (27 up, 36 down).
The new options measures clearly point out that returns are superior following five-day periods of bearish sentiment and subnormal following five-day periods of bullish sentiment. By measuring bearishness (put ratio) separately from bullishness (call ratio), we can tease apart periods in which the traditional put/call ratio is high because of high put activity vs. low call activity. More soon to come...