Understanding Options-Based Sentiment in the Stock Market

I'm currently working on creating better indicators of stock market sentiment.  Above is a five-day moving average of the equity put/call ratio:  the ratio of put volume traded for all listed individual stocks divided by their call volume (no index volume included; raw data from e-Signal).  You can see that spikes in the ratio have corresponded pretty well with buying opportunities in the past year.

Of course, the put/call ratio is influenced by price change.  In fact, the correlation between the percentage of stocks trading above their five-day moving averages and the five day equity put/call ratio is less than -.56.  In other words, when markets have been strong over the short term, there has tended to be call buying relative to put buying and vice versa.  Perhaps the most important takeaway here is that sentiment in stocks has been very fickle with traders/investors shifting over surprisingly short time horizons.

Looking at 2014 to the present based on a simple median split, if you bought the SPX when the proportion of stocks that closed above their five-day moving averages was high, the next five days averaged a gain of +.14%.  If you bought when the proportion of stocks above their five-day averages was low, the next five days averaged a gain of +.38%.  If you bought when the five-day equity put/call ratio was in the top half of the distribution, the next five days averaged a gain of +.44%.  If you bought when the ratio was low, the next five days averaged a gain of only .08%

In short, over the past year, short term weakness has led to relative bearishness and superior short term returns.  Short term strength has led to relative bullishness and inferior short term returns.  Teasing apart sentiment and concurrent price change could provide a purer view on sentiment that might inform short-term trading decisions and the execution of longer-term positions.

Further Reading:  Stock Market Sentiment
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