Measuring Stock Market Sentiment: The Equity Put-Call Ratio

The most recent posts have focused on several important dimensions of short-term stock market behavior:  Buying and Selling Pressure; Volatility; and Breadth.  Above we see yet another key dimension:  sentiment.  My favorite measure of sentiment is the put-call ratio specific to individual stocks trading listed options.  I have found this measure to be significantly better at predicting short-term price movement in SPX than the put-call ratio for index options.  

As you can see from the chart above, covering 2014 to date, spikes in the equity put-call ratio have been associated with good buying opportunities in stocks.  (Data from e-Signal and analyzed/charted in Excel).  Forward returns have been restrained following periods of low put-call ratios.  If we go back to 2007, when the equity put-call ratio has been in the lowest half of its distribution, the next 10 days in SPX have been unchanged.  When the equity put-call ratio has been in the highest half of its distribution, the next 10 days in SPX have averaged a gain of +.49%.

It's a great illustration of how following the herd produces suboptimal market results.  It's when stocks are most unloved that they've produced the best returns.  

Further Reading:  The Relative Put-Call Ratio
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