Stock Market Psychology: Equity and Index Put/Call Ratios

In my most recent post, I showed that there is a near-zero correlation between the daily equity put/call ratio and the daily index ratio over the past several years. Whereas the equity ratio has shown more call than put activity over that period, the index ratio has been skewed toward puts. These factors lead me to believe that different groups of market participants are active in the equity and index options markets. Are they both accurate measures of market psychology, despite their differences? I decided to take an initial look.

Going back to 2004 (N = 748 trading days), I divided the sample in half based upon whether the five-day put/call ratios were relatively low (more bullish) or high (more bearish). I then looked to see how the S&P 500 Index (SPY) behaved over the following five days.

When the five-day equity put/call ratio was relatively low (N = 374), the next four days in SPY averaged a loss of -.03% (190 up, 187 down). When the five-day equity put/call ratio was relatively high (N = 374), the next four days in SPY averaged a gain of .29% (232 up, 142 down). This is quite a difference. It suggests that the common wisdom has held true: market returns are superior when equity options participants are relatively bearish and are subnormal when equity options participants are relatively bullish.

Now let's look at the index put/call ratio. When the five-day index put/call ratio was relatively low (N = 374), the next four days in SPY averaged a gain of .08% (197 up, 177 down). When the five-day index put/call ratio was relatively high (N = 374), the next four days in SPY averaged a gain of .19% (225 up, 149 down). Although the difference is not as dramatic, we see a similar pattern among the index option ratios: when relatively bullish, market returns have underperformed; when relatively bearish, market returns have been superior.

Interestingly, five-day index put/call ratios have correlated with five-day equity ratios by only .05--meaning that they are essentially independent of one another. My best interpretation of the data is that both are measuring sentiment, but among different market participants. The equity put/call ratio is assessing the psychology of speculative traders; the index ratio is tapping the psychology of those using index vehicles for hedging purposes. While there are obviously other uses of the options to be considered, it does appear that the sentiment of these groups is worth tracking for the short-term trader. In my next post, I will examine these ratios on a relative basis (i.e., when they are elevated or depressed relative to their moving averages).

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