Saturday, May 12, 2007

The Equity Put/Call Ratio Traces a Wall of Worry

Here we see the 15-day equity put/call ratio (pink line) plotted against the S&P 500 Index (blue line) from January, 2004 to the present. Note how spikes in the options ratio have marked excellent intermediate-term buying opportunities during this period.

Perhaps even more interesting, observe how we've been riding a wall of worry during this bull market. We've been tracing out higher lows and higher highs in the equity put/call ratio. While some have referred to this market as a "bubble", it is difficult to make the case that we're seeing excesses of optimism that would be characteristic of a market peak.

With respect to the present market, we can see that troughs in the put/call ratio have tended to precede price tops during market swings. We've yet to see such a trough in the recent market, suggesting that we could have further to go on the upside during this swing.


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T. said...

Hi Brett,

Have you read these research pieces by the CXO on the limited usefulness of the put-call ratio?

And this one:

Brett Steenbarger, Ph.D. said...

Hi T.,

Yes, I've seen these posts; CXO does great research. My own work suggests that it is the relative changes in put/call activity and not absolute levels that are most helpful--particularly over that intermediate time frame where CXO did find a correlation with future returns. And, if the ratio does have a random relationship with future returns, I can only express my gratitude that its non-predictive elevations turned me bullish in early/mid March. :-)


Thomas Ott said...

Hi Brett,

I do a lot of neural net modeling and (currently focusing on volatility modeling) I agree with your above comment. The relative changes in put/call activity and volatility are way more important (and lucrative) than some absolute level. Usually these events are clustered together.

Neural Market Trends