Tuesday, August 12, 2014

Relative Equity Put/Call Ratio: What We Can Learn From Stock Market Sentiment

One of the psychological curiosities of the stock market is that we tend to see euphoria when shares are their most overvalued and despondency when they are trading at greatest value.  It's for that reason that sentiment gauges can be useful in tracking market cycles.  One of my favorite measures is the ratio of put options traded to call options traded for every stock with listed options across all options exchanges.  Note that this is an equity put/call ratio only; it does not include index options.  The latter, I've found, are more frequently used as hedging vehicles and thus are not as reliable as sentiment gauges.  (Data available via e-Signal; ratios derived from CBOE listed options are available from Index Indicators). 

Going back to 2010, let's express each day's sentiment as the ratio of the current day's equity put/call ratio to the average ratio of the prior 40 days.  When this relative put/call ratio has been in its lowest quartile (current put/call ratio low relative to prior 40 days), the next five days in SPY have averaged a gain of only .04%.  When the relative put/call ratio has been in its highest quartile (current put/call ratio high relative to prior 40 days), the next five days in SPY have averaged a gain of .62%.   Overall, from 2010 to the present, the average five-day gain has been .29%.  

Being a buyer when others have been particularly bearish has been a winning strategy in recent years.  We saw this most recently when put/call ratios became elevated several days ago following the market drop, leading to the rally of the past two trading sessions.  Interestingly, yesterday's put/call ratio dropped to below average following highest quartile readings on July 31, August 1, and August 5.  Such rapid shifts in sentiment have helped make stocks noisy to trade on a longer-term basis.  More on this topic in an upcoming post.

Further Reading:  Stock Market Social Sentiment